Navigating China’s cycles through a long/short lens , Report
UBS O’Connor seeking potential alpha opportunities in China
Sail with lift and drag in China investing
A summary of the China Forum 2022 on 20 October 2022
Sailing derives power from the wind and is about balancing the fundamental forces at play. A lift or drag can propel a sail craft forward in both downwind and upwind situations—with the right angle of attack.
China investing in many ways has sailed against the wind this year amid heightened geopolitical tensions, lingering property market woes and a slowing economy. This week’s stock market reaction and industry outflows from China have shown how reactive investors remain, despite the long-term outlook. To stay on the desired course, should investors change tack? Or is China still good value if you can stay the course? The team of China experts at UBS gathered at the China Forum 2022 and shared their insights on how to negotiate the different market forces. The following is a summary of the discussions.
The 20th Party Congress and policy continuity
The 20th Party Congress and policy continuity
- The Party Congress that concluded on Saturday 22 October is an important milestone but it will take some time for the full implications to become clear.
- The Party Congress mainly focused on leadership changes and the CPC Constitution Amendment, with only high-level discussions on economic development.
- The next key economic event to watch will be the “Two Sessions” in March 2023, where government-related positions will be officially unveiled at the National People’s Congress. On economic policy, the next two top meetings will be the December Politburo meeting and the 2022 Central Economic Work Conference (CEWC), both to be driven by the new leaders. At the CEWC, the top leaders will discuss policy targets and priorities for the next year, including GDP targets.
- In President Xi’s report to the Party Congress, he emphasized that China would accelerate creating a new development pattern and pursue high-quality development. China would keep to the reform direction of a “socialist market economy” and continue high-level opening. The speech also reiterated that the Party would “unwaveringly” encourage, support and guide the development of the private sector, fully realizing the “decisive” role of the market in resource allocation, with the government playing a better role. This may dispel some market concerns about economic growth. However, President Xi did emphasize that development needs to be "for the people".
- We believe that government responses to—e.g. COVID policy and property market crisis—in many ways have been on hold until after the top level leadership changes. We expect more economic stimulus and decisive actions after the congress, and we may adjust our investments accordingly.
Equities await a turning point; on the path to normalization with good long-term value to be found
Equities await a turning point; on the path to normalization with good long-term value to be found
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- Around the world we are witnessing macro, investor and policy capitulation across markets, but we believe that signs point to the nearing of a turning point.
- For China, the worst of the COVID-related lockdowns and disruptions seems to be over. The economy is on a normalization path as activities in commerce, investment, consumption and services have picked up. We see production bouncing back on the workforce’s flexibility to adjust for rapid changes in supply and demand, which reduces supply chain risk and improves cost efficiency for multinational companies. That advantage is unlikely to change in the short term, especially when developed markets are under acute inflationary pressure.
- Implementation of regulatory actions will probably continue, but we believe the most severe period is behind us. More clarity and support have come through on the platform business, data regulation, anti-monopoly law and property sector in recent months.
- Despite the ongoing real estate turmoil, bad loans remain at a manageable level among all property loans. We believe the government could do more to stabilize the property market since it takes a long time for investor nervousness to subside—and a stable economy requires a stable property market.
- Chinese equites are still trading at a tremendous discount as extreme investor pessimism has created a vicious cycle. Since most of the stock weakness is not based on fundamentals, any positive factor can trigger a rerating. It is painful waiting for the turning point, but we believe we will see stronger policy action after the congress.
The highs and lows in bond investing: we are cautiously optimistic on China
The highs and lows in bond investing: we are cautiously optimistic on China
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- China has been in a different interest rate cycle from major developed markets (DMs) during the past three years as DM inflation soared while inflation for China—a net exporter and net creditor—stayed muted. This has led to stable yields for China sovereign bonds in sharp contrast to DM bond yields, which have spiked dramatically so far this year.
- Thanks to an onshore bond rally, China sovereign bonds have delivered positive gains year-to-date, compared to losses of major DM sovereign bonds. Even if we take the US dollar (USD) appreciation against most major currencies into account, helped by the lower volatility of Chinese yuan, China sovereign bonds still beat major DM sovereign bonds in USD terms, and have offered good diversification for investors’ global fixed income portfolio.
- On the other hand, while the real estate driven selloffs in the China USD denominated high yield bond market is not news, more recently other parts of the market have also softened with global high yield markets due to overall risk-off sentiment. For the China USD real estate high yield sector, weak property sales have yet to improve, despite a supportive turn in policy and already distressed valuation in bonds.
- There is a need for patience and we are cautiously optimistic about China USD denominated high yield and investment grade bonds. We are managing risk prudently against high global inflation and recession fears.
Reasons for a relative value approach: an effective approach to minimizing downside risk
Reasons for a relative value approach: an effective approach to minimizing downside risk
- We expect uncertainties to persist, at least in the near term, hence it will likely continue to be a challenging environment to generate competitive risk-adjusted returns through a more traditional approach.
- We view the regulatory reforms based on the common prosperity theme in the past 12 to 18 months are intended to create a level playing field for companies across sectors—and ultimately seek to achieve the overarching goal of better equality for the people.
- With the recent session of the National Party Congress, our focus is on understanding the long-term and short-term priorities for the new government and identifying the structural trends as well as investment opportunities that emerge from these. Our long-term outlook on China investing is positive as we believe that the reforms and opening-up policy will remain as the bedrock for the new government.
- However, external inflation stress together with China’s continued implementation of a stringent COVID policy and weakness in the property sector are some of the primary reasons for a defensive position this year.
- We believe a relative value approach may be a more effective strategy to minimize downside risk in such a volatile market environment while also allowing investors to maintain exposure to the long-term China growth opportunity.
Be more dynamic with asset allocation
Be more dynamic with asset allocation
- From an asset allocation point of view, we try to achieve a return profile that is positively correlated to risk assets but lower in volatility and a smoother journey through investing in a range of different asset classes with enough diversifications.
- It has been a difficult year for multi-asset, USD investors, but we have taken the time to rethink our strategy from a structural point of view and revise our capital assumptions to reflect changing market dynamics.
- At this juncture, we on the Investment Solutions team have a preference on China equities over credit as we think China equities could be better positioned for a rebound should market sentiment turn positive. We have a preference for onshore over offshore equities because we believe that onshore equities appear to be more responsive to stimulus and yet more insulated from negative global risk sentiment. Within fixed income, we favor Chinese government bonds given its diversification benefits.
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