China’s weakness a challenge, not a crisis

Both cyclical and structural headwinds have contributed to this macro deterioration. Multiple years of tightening policy on the property market, internet platform companies, and mobility restrictions have resulted in a loss of consumer and business confidence, dampening the willingness to spend, hire, and invest. The ongoing developed economy rotation of demand from goods to services has also weighed on demand for Chinese exports. Most importantly, the loss of credit-fueled property development as a growth pillar will be difficult, if not impossible, to fully replace.

China’s transition from this growth model to one in which consumer spending plays a larger role will be an ongoing structural challenge.

So far, China has cut several policy rates and pledged that local governments will increase infrastructure investments, support urban village renovation programs, support electric vehicle purchases, and relax mortgage rates. However, the pace, strength, and nature of the stimulus have not kept up with the rate of macro deterioration. Many of the policy actions help the supply side by reducing costs, but the Chinese economy’s problem is insufficient demand.

Although direct cash handouts can be one of the quickest ways to boost near-term growth, policymakers do not believe that these would be that effective or efficient in China. In future, the forceful execution of a coordinated policy package – including ensuring unfinished homes are completed, easing home purchase restrictions, direct support for consumer spending, and more central government support for local governments – would be needed to meaningfully bolster the Chinese growth outlook, in our view.

In the near-term, property developer default headlines, the high youth unemployment rate, and low household and business confidence will likely put further pressure on economic activity, and the housing sector in particular.

But since regulators have been monitoring the risks surrounding major developers and asset managers for years, we think the probability of a systemic financial crisis remains low. The targeted policy support to date, coupled with nascent signs that global manufacturing activity may be inflecting positively, may provide a sufficient cushion to prevent increasingly negative outcomes for the Chinese economy.

Our highest conviction position on Chinese assets is to be long the US dollar versus the Chinese renminbi. Growth and interest rate differentials have shifted substantially in the US’ favor.

We have a neutral view on Chinese risk assets despite this sluggish growth outlook. Both stocks and credit are very cheap after having suffered material drawdowns. Periods of extremely negative sentiment on the Chinese economy have often been followed by strong forward returns for stocks. The risk of continued deterioration in the Chinese economy that leads to continued underperformance in domestic risk assets must be balanced against the potential for additional policy support that fuels a squeeze higher.

At the global level, China’s loss of economic momentum this year is being offset by continued resilience in US activity.

We believe that if Chinese growth soon stabilizes, which is our base case, there should be no meaningful increase in recession risk – particularly for the US. China’s malaise is likely to adversely impact Europe more than the US because of higher trade linkages, particularly in manufactured and industrial goods. And there is one silver lining to this softness in the world’s second largest economy: China’s mild deflation is helping to mitigate the risk of another wave of inflationary pressures in developed markets.

We are monitoring for more concrete supportive measures after the Politburo meeting. As the government has acknowledged the current economic challenges, we believe the chances of meaningful stimulus have increased. Meanwhile, valuations are compelling. Price-to-book valuations of MSCI China are currently lower than March 2020 during the peak of COVID concerns, though China has reopened, while MSCI China A valuations are on par.

We continue to believe that Chinese equity markets hold significant opportunities for active investing. We believe that high quality companies with competitive advantages should deliver results in the long run as investors focus on a return to company fundamentals and cash flow generation.

Considering the downside risks within the Asian High-Yield market, we remain around market-value neutral in the China property sector. Based on our bottom-up issuer and issue selection process, we continue to select developers that either have a large chance of survival despite the currently prevailing negative sentiment or have better recovery potential due to the quality of the underlying assets. It is worth noting that the weight of the China real estate sector within the Asian Fixed Income indices is now a fraction of its peak.

Onshore Chinese Yuan (CNY) denominated Chinese government bonds have rallied on the back of the recently released weak data. Despite that, investing in China fixed income and hedging the exposure back to US dollars still offers an attractive yield coupled with low correlation with other asset classes.