Opportunities and challenges: Why China and Emerging Markets may still be attractive

Too big to ignore, yet unpopular as rarely in years, if not decades: Investing in China, whether through the stock market or direct investment, is currently out of fashion. In this article, Mark Frielinghaus describes the background to the current scepticism about investing in China and how investors can position themselves in such an environment.

Mark Frielinghaus, CFA
Portfolio Manager Equities

A look at the returns of the world’s largest stock markets in 2023 is a quick reminder of why the Chinese stock market is currently out of favour. While the US, Japan and even Europe are posting double-digit returns despite geopolitical concerns and persistently high inflation rates, the Chinese stock market continues to tread water. In fact, it has been in a steady downtrend since the first quarter of 2021, with a performance of -6% (in USD) so far this year.

Figure 1: Stock market development
Source: Bloomberg

The correlation of equity market returns across regions remained very stable in 2022, with prices falling in tandem. This was triggered by unexpectedly high and persistent inflation rates, coupled with significant increases in key interest rates by central banks in most developed countries. In addition, fears of a global recession due to global supply chain issues and geopolitical uncertainty from the Russia-Ukraine war dampened investor sentiment. However, in 2023 the focus was on robust economic data, particularly in the US, which led to a positive change in sentiment. The resilient labour market and stable consumption appeared to be enough to boost equity markets not only in the US but also in many other countries.

In Asia, however, the recovery was sluggish as China proved to be an unexpected drag, with lasting negative consequences for the stock market. So what held China back? Here we look at the three main reasons:

1. China’s conservative approach challenges globalisation

The economic recovery in the industrialised countries that took place from the second half of the year after the initial lockdowns in spring 2020 was slow or unexpectedly sluggish in China. China’s handling of the covid pandemic in 2021 and 2022 revealed a policy shift away from the previous primacy of economic growth towards domestic security and surveillance.

The result was an exacerbation of global supply chain problems, as what was once the world’s largest work bench increasingly sputtered. Critical manufacturing processes in Western countries were disrupted by supply shortages. Many American and European companies and governments began to rethink. Globalisation had clearly passed its peak. The current trend is towards nearshoring, i.e. moving important production processes and primary products back to the domestic market, despite higher costs. This is also contributing to further price increases in the developed world.

2. Foreign policy tensions

On the political front, China’s stance on the Russia-Ukraine war, as well as tensions with Taiwan and the US, added to investor concerns. Trade restrictions and punitive tariffs, particularly in the technology sector, have recently re-emerged as an issue, having receded into the background following the election of President Trump.

3. Troubled property market

Apart from international trade relations, China’s domestic economy is also facing significant challenges. The Chinese property market is the first to be mentioned. For several years now, a number of companies in the Chinese property sector have been struggling with liquidity problems and over-indebtedness. The quasi-insolvency and restructuring of property developer Evergrande has weighed on the markets since the first payment difficulties in 2021. After trading in Evergrande had been suspended for around a year and a half, the stock opened a further 87% lower at the end of August. In September, the company defaulted on a domestic bond and its chairman was arrested.

In addition to Evergrande, two other significant defaults occurred in the third quarter of 2023 with Country Garden and Sino-Ocean. The companies missed bond interest payment deadlines.

Figure 2 shows the evolution of the property market in China. After a slow decline in sales in the mid-2010s due to high price rises and, in many cases, speculative investment without real demand for housing, there was a brief catch-up effect after the first wave of the Corona pandemic in 2020. Since then, however, the trend has been steadily downward.

Figure 2: China’s property market significantly weaker than retail
Source: Bloomberg

A recovery in China’s property sector will not happen overnight. There has been a lack of political will to provide monetary or fiscal stimulus to property buyers. As the chart below shows, China’s property sector used to regularly contribute between 3% and 4% to China’s GDP, but is now acting as a drag on the economy. Several investment banks are forecasting a protracted recovery, with the property sector not expected to make a positive contribution to economic growth until at least 2033.

Figure 3: Contribution of the Chinese property sector to GDP growth
Source: Goldman Sachs
August marked by highest outflows since 2014

All in all, the last two to three years have seen the development of what can be described as an investor-hostile environment. As mentioned at the outset, this has not been without consequences for stock prices in China. Western investors are withdrawing money from the People’s Republic of China at an unprecedented rate. The Northbound Connect market is an example of how monthly inflows are currently collapsing. The Northbound Link allows foreign investors to buy and sell shares in mainland China. In August, foreign investors withdrew 90 billion yuan worth of funds. This is the largest monthly outflow since the Stock Connect programme was launched in 2014.

Figure 4: Monthly net inflows into China via Northbound Stock Connect (in RMB bn)
Source: Bloomberg

Many investors currently report a significant underweight to China in their equity allocations. For active investors with a long-term planning horizon, China is sometimes considered uninvestable and is excluded from strategic asset allocation. It is not uncommon to see mandates being sought specifically for emerging markets ex-China. In summary, the picture is very negative and the sentiment towards Chinese equities very pessimistic. The clear consensus is to underweight China in global portfolios.

Unlock the potential of China and Emerging Markets with an alternative investment approach

Timing stock markets and asset classes is notoriously difficult. However, it has been shown that periods of overly pessimistic sentiment indicators often offer good investment opportunities.

Moreover, even during the crisis, a large equity universe such as China (>3000 stocks) offers numerous attractive investment opportunities. In particular, a defensive approach that favours stocks with low volatility and low cyclical sensitivity can be used to invest successfully over the long term.

The Chinese market is extremely concentrated in comparison to other popular indices. A supposedly passive investment is a big bet on a few large technology stocks. Over the long term, the second tier of companies is more stable, providing investors with an attractive investment opportunity regardless of the stock market environment.

The different market segments in China, offshore and Hong Kong-listed stocks on the one hand and the mainland/onshore market on the other, also offer opportunities. The chart below shows the added value of the Quoniam Emerging Markets Equities MinRisk strategy in relation to Chinese equities since 2020. Even though 2021 and 2022 will see large absolute losses in the Chinese equity market, it has been possible to generate consistently high added value within China. This successful trend continues in 2023.

Figure 5: Value added in China within a global emerging markets portfolio
Source: Quoniam Asset Management GmbH
Outlook: First signs of stabilisation?

China and emerging markets as a whole are currently out of favour. The consensus is to underweight China in global portfolios. However, despite all the difficulties, there are signs of economic stabilisation, albeit at a low level. Incentives for property buyers in the form of cheaper loans and less red tape are on the way. Fiscal relief is currently focused on the corporate sector. So there is still plenty of scope to support private consumption. Monetary policy also has room for manoeuvre, as price developments are deflationary compared with the developed world.

Although the macroeconomic data do not point to a rapid recovery in China, the capital markets often take the bottoming out of the economy as a starting point for positive price developments.