How to consider playing the China wildcard

For much of this year investors have had to navigate an uncertain macroeconomic environment. Market sentiment has shifted in response to geopolitical conflicts, election results, the turn of the global interest rate cycle and more.

Through these testing times, China is a wildcard. Until the surprise round of easing measures in September, many believed Beijing had not been doing enough to support the country’s slowing economy. The broad set of supportive measures were more comprehensive in scope and expectations, and in dramatic fashion, it sent the markets into a remarkable rally.

Going into the National People’s Congress (NPC) Standing Committee meeting in November, markets were volatile but hopeful for more. However, while the policy direction is clearer than ever, the lack of new borrowing or spending measures to boost consumption or the property market disappointed investors and sent markets lower. External factors such as possible higher tariffs from the newly elected US administration also had a compounding adverse effect.

Because policies have an outsized impact on Chinese markets and its economy, we too believe that more should be done – and, crucially, that more will be done. Not only is more needed on both the fiscal and monetary fronts, we believe that fundamental changes to protect consumers, investors and businesses in the areas of property rights, shareholder rights, deregulation and capital market liberalization would go a long way in reviving overall confidence. Despite the near-term stimulus letdown, we think greater policy support is still on its way given the forward guidance in the past few months; Beijing might also be holding off until there is more data on incremental improvement in the economy as well as more details on the US tariff strategy.

Timing of the stimulus aside, it is important to look at the big picture. China has made significant progress in its structural transition away from the old economic model by derisking the property market and strengthening competitiveness in many manufacturing and exports sectors. While the road ahead might still be bumpy, the right stimulus could prevent China from entering a deflationary spiral, smooth the transition process, and accelerate the timeline of the recovery. We are seeing the first signs that the stimulus measures are having a positive impact on certain sectors: retail sales picked up in October. A full recovery, however, will take time.

Taken together, we believe the most challenging period for China’s transition is likely behind us. For the Central Economic Work Conference (CEWC) in December we expect to hear more on Beijing raising the deficit, expanding the special local government and ultralong treasury bonds, increasing central transfers to local governments, as well as more support directed at consumption, the property market and infrastructure.

Markets are inherently forward-looking, and we think a more decisive stimulus response and a turnaround for the markets in the next 12-18 months could be in the cards, bringing along new alpha opportunities for the long term in the various asset classes, and especially for an active multi-asset strategy.

At this policy pivot juncture, there are plenty of opportunities to invest in China equities, given the number of high quality companies with attractive valuations. Despite the threat of more US tariffs and sanctions, Chinese companies have demonstrated resilience under such pressure. We particularly like companies that have a growing presence in foreign markets.

With earnings growth generally healthy, we believe that companies that focus on returning value to investors via dividend payout and share buybacks should also do well. While an uncertain stimulus timeline had again made some offshore investors think twice before getting back into China equities, onshore investors are more optimistic.

Before the September rally, Greater China USD high yield credits had already recovered from late last year and earned a spot among the best performing asset classes year-to-date in fixed income. Market sentiment on China had been overly bearish last year, which kept China USD high yield valuations trading at extremely low levels. However, as investors realized that most defaults have already happened a strong rally ensued earlier this year.

The Asian and China USD high yield markets have experienced a significant structural change over the past four years, with the weighting of China real estate sector in JP Morgan Asian high yield index dropping from 38% to 7% as of today.¹ The market is therefore more diversified than before. At the same time, the default cycle in China and rest of Asia looks to be peaking. We think that this creates a solid foundation for both asset classes to continue to perform into next year. Credit selection is critical here; generating alpha and adding value require a close look at the credit issue and issuer. For Greater China credits, we currently prefer high yield over investment grade because there are more potential credit alpha opportunities.

Our longer-term view of China is constructive, but the country’s transition could bring more market volatility. Stock performance could become more divergent, even within the same sector, which a long/short investment approach could potentially capitalize on.

While we don’t have a sector preference, we like market leaders that have reinforced their leadership position in the past cycle through improved financials, better sales, and larger market shares. These companies tend to deliver solid returns to shareholders, and they have the potential to consolidate the industry they are in.

Going forward, artificial intelligence, state-owned enterprises, and energy transition will likely continue to be our main investment themes, giving us many interesting alpha ideas in our long and short books.

As global markets become more concentrated and unpredictable, diversification has again been brought to the fore as the central tenet of investment practice. China could be the wildcard in a diversified approach.

¹ Source: Bloomberg, data as of 18 Nov 2024.