COULD A RABBIT POP OUT OF YOUR PORTFOLIO?

STOCK MARKET ANALYSIS

On Sunday, January 22nd, China will also enter 2023, as it celebrates the beginning of the lunar year of the water rabbit. The rabbit may seem fragile and not very combative, but this animal symbolises prosperity and peace, while water represents the ability to adapt. So 2023 looks set to be a year of compromise and hope... everything that investors love. In his first speech of the year, President Xi Jinping adopted a measured tone, less provocative than the rhetoric of the past three years:

"We cherish peace and development and value friends and partners". There was no call for unification with Taiwan, unlike the previous year, and no warnings against outside forces as at the Communist Party Congress in October.

Investors seem to share the positive opinion of both astrologers and political scientists: China's main stock market indices have performed very well since January 1st, in line with the fourth quarter of 2022 (see Chart of the Week). Our analyses also corroborate this enthusiasm, both from a cyclical and structural point of view.

1. Economic factors are improving

• After several difficult years, the Chinese government has gone into action. Fiscal and monetary policies have become very expansionary, aimed at encouraging the economic recovery of small businesses and household consumption. While the government provides tax incentives, the central bank lowers rates and stimulates lending.
• Purchasing managers' confidence is bottoming out. It will follow credit dynamics in the coming months (see Fig. 2), positively surprising the economists' consensus. This will not be the case everywhere in the world.

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• Most sanitary restrictions were lifted in mid-December. The world's second largest economy is experiencing a massive epidemic wave, but its businesses are poised to operate at full capacity.
• After a two-year ban, Australian coal imports are about to be allowed again. In the context of a global energy crisis, China is keen to avoid a blackout situation.
• The regulatory crackdown on technology giants such as Alibaba, Baidu, Bytedance, Didi, JD.com, Meituan or Tencent seems to be coming to an end. Under pressure to work in line with government guidelines, these companies will be able to expand their business again.
• The "three red lines" that exacerbated the housing market collapse from August 2020 have now been modified. This means that developers will be able to further increase their debt ratios, notably by excluding the acquisition of distressed assets from these ratios.
• Inflationary pressures are much lower in China than in the rest of the world. Prices rose by 1.8% in 2022, compared to 9.2% in the Euro Area, 7.1% in the US, and even 3.8% in Japan, the nation of deflation (see Fig. 3).

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The Chinese economy is expected to grow by 6% in 2023, while most developed economies will experience an historic recession. After suffering from lockdowns and then the resurgence of Covid cases, domestic demand will rebound strongly, as it did in 2021 in the main developed economies. Chinese households have accumulated substantial savings over the past three years (see Fig. 4), which are now waiting to be spent. The latest figures on Chinese mobility (see Fig. 5) tend to confirm that they are not only going to work, but also shopping.

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Investors, who eventually capitulated, i.e. sold their Chinese stocks in 2022 (see Fig. 6) and drove valuation ratios to historically low levels (see Fig. 7), will become interested again. Of course, risks specific to Chinese stocks remain: the political system is not democratic, the government can interfere in the industrial and business activities of private companies, geopolitical tensions are high between Beijing and Washington, the listing of Chinese stocks in the United States (ADR) is regularly questioned, etc. These risks persist, but they are currently priced in and, by mirror effect, investors who accept them will be heavily rewarded.

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The appreciation of the Chinese stock market, which began in November, could even accelerate. According to IHS Markit data, short positions in Chinese ADRs declined in December (see Fig. 8). If sentiment continues to improve in 2023, the need to cover all of these positions will help the market rise.

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2. Structural fundamentals are supportive

Beyond the cyclical aspect, Chinese equities have a structural interest for investors.

• China is an economic giant. Thanks to a long-term policy strategy, steady urbanisation, an educated population, knowledge acquisition, productivity growth and the pursuit of self-sufficiency in the sectors of the future, China has become an economic leader in many industrial fields, including advanced technologies. The strong growth of its activity should enable China to become the world's leading economic power by 2028, ahead of the United States and the European Union.
• The regulatory environment is improving. China is gradually opening its domestic financial markets to foreign investors, with increased trading opportunities and access to more complex financial products.
• The Chinese market is too big to ignore. Benchmark providers, such as MSCI, are increasing the weighting of China in their various indices. Chinese equities will account for around 5% of the MSCI ACWI in 2024, compared with 4% in 2021, 3% in 2017, 2% in 2008 and 0% in 2000 (see Fig. 10). This trend will continue to grow until China's final weight in global indices is close to that of its economy, i.e. 20% (see Fig. 9).

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• Capital flows will accelerate. Historically, investors have had few Chinese equities in their asset allocation. A survey carried out by BlackRock in 2020 showed that the average allocation was less than 3%, not directly but through broader exposure to emerging markets. There will come a time when investors cannot assume the underperformance of their portfolios due to an underweight in Chinese equities. Within a few years, chief investment managers, strategists, asset and portfolio managers will clearly dissociate China from emerging markets. In doing so, by increasing their exposure to reach China's weight in global equity indices, they will generate a steady flow of capital.
• There are still pockets of inefficiency. While Chinese offshore stocks (H-shares) are mainly traded by institutional investors, domestic stocks (A-shares) are mostly held by individuals in China (see Fig. 11). Similarly, according to data from the People's Bank of China (PBoC), foreign investors hold only 4.3% of the domestic A-share market. This anomaly, linked to the youth of the stock market, allows investment professionals to exploit inefficiencies.
• Chinese equities provide diversification. Recent years have highlighted the important role that Chinese equities can play in providing resilience to strategic portfolios. They regularly outperform, particularly when the US dollar weakens (see Fig. 12). This scenario has a high probability this year, as the Federal Reserve moves closer to the end of its rate hike policy and other major central banks also raise interest rates. Carry trades will be less positive and demand for dollars will weaken.

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Many investors build exposure to China by using benchmarks, such as the MSCI Emerging Markets, that are not specific to Chinese equities (see Fig. 13). Still others opt for investment vehicles, such as the Footsie China (see Appendix 1), which give excessive weight on offshore companies (H-shares) and large caps. While some of these companies are becoming global leaders in their sector, others are government-controlled and have low exposure to faster-growing domestic demand. To gain exposure to the full range of activity in China, investors should also look to smaller onshore companies (see Fig. 14): A-shares and the Nasdaq-like STAR market reflect a modern economy in innovative sectors, including biotechnology, artificial intelligence and 5G.

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Conclusion

While global growth will weaken considerably in 2023, the Chinese economy will be on an upward trajectory. This exceptional decorrelation, linked to the end of the zero-covid strategy and the powerful support of fiscal and monetary policies, bodes very well for Chinese equities, including small caps that are naturally tied to domestic demand. Investors will need this allocation to generate some magic and prosperity in their portfolios during the year of the rabbit.

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RETURN ON FINANCIAL ASSETS

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