The ongoing slump in Chinese assets over the past three years has left many investors wondering if China is still investible, and whether investors should invest in emerging markets or Asia, without China in it. Further weighing on sentiment has been a recent credit rating downgrade for China’s sovereign bonds. As of Dec. 6, the Morningstar China Index fell 11.9% for the year. Since 2021, the market has plummeted by 45%.
China Stocks Have Been Hit by Downgrades
One day after China’s sovereign downgrade, on Dec 7, rating agency Moody’s Investors Service also revised downward the ratings for 44 Chinese companies.
Eight Chinese banks, including Bank of China (03988) and ICBC (01398), received a new rating of ‘Negative.’ E-commerce giant Alibaba (09988), internet and gaming behemoth Tencent, and telecom company China Mobile (00941) were among the companies whose credit rating outlook was downgraded.
Moody’s said the reasons for the downgrades include “broad downside risks to China's fiscal, economic and institutional strength” and “increased risks related to structurally and persistently lower medium-term economic growth and the ongoing downsizing of the property sector.”
Can things get worse for China stocks? We asked three managers what they thought.
China Stocks Have Not Yet Hit the Bottom
Wenchang Ma, portfolio manager at Ninety One, thinks Chinese stocks haven’t seen a bottom, despite the fact that valuations have inched beneath the historical average. She also thinks “It will be unfair to say that all the downside risks are out of the door.” She co-manages Bronze-rated Ninety One All China Equity Fund (on the cheapest share class), which has US$ 452 billion under management.
She highlights two risks:
1. China Property, and
2. Inflation
She names the property downcycle as one of the lingering risks, which poses uncertainties about how long this slump is going to last and when the initial signs of stabilization will emerge. A further downturn in the sector could negatively impact the overall economy, especially considering its size.
“Although after the deleveraging process, the sector now contributes a lesser proportion of the overall economy compared to its peak, it is still a sizeable chunk. The most recent estimate is pegs the sector at over 20% contribution to the Chinese GDP,” Ma notes.
Another top-line risk on Ma’s mind is inflation. Unlike developed markets, Ma is wary of how long the sluggish inflationary environment is plaguing economic growth. She adds: “The sentiment side for private entrepreneurs for consumers needs to stabilize and that needs to happen as fast as possible.”
Managers Call for More Policy Support
Ma is calling for more policy support such that the property woes can be resolved, or at least stabilized.
“The policy stance is very clear, and the government is very supportive in rolling out more measures to stabilize the property market. The reality is at the moment inventory levels in the Chinese property sector are still quite high,” says Ma.
For example, she says, property inventory in the most important cities such as Shanghai is deemed healthier. But as it goes down the city tiers, unsold homes in the second-tier cities amount to a 1.5-year inventory. Worse still, even lower-tier locations are sitting on more than two years of inventory. “That's going to take some time to digest. There is a need for more support,” she adds.
Tai Hui, chief market strategist for APAC at JP Morgan Asset Management, also echoes the view that policy support will be of utmost importance. “I'm not expecting a bazooka, but more policies supporting the property sector are going to be important,” Hui says.
“I know that the property sector and tech don't seem to be connected, but the truth is the property sector is linked to the broader economy, and that is linked back to the ability to do business. So that to me is also an important signal,” he continues.
India and Japan Benefitted from China’s Weakness, But That Could Reverse
As soon as the market is satisfied with a greater magnitude of policies and transmission, this could effectively draw capital flows back to Chinese assets.
Ernest Yeung, who manages Gold-rated T Rowe Price Emerging Markets Discovery Fund, puts a casual relationship between outflows of China and capital influx into neighboring markets. “The strength of India and Japan’s equity markets was a direct linkage to the weakness of the Chinese stock market,” says Yeung. The key catalyst to reverse that trend would be determined by the policy objectives of the Chinese government in the next 12 months.
“If [the Beijing government is] more aggressive in rescuing the economy, so we won’t have the disappointment in growth anymore, then Chinese equity could recover. When that recovers, that flow is going to reverse. The strength of India and Japan may fade a little bit while money could come back to China. It all hinges on what Beijing does.”
Keep an Eye Out for a Rapid Switch in Sentiment Over China
At this point, Yeung thinks investors cannot afford to be substantially underweight in China. For this very exposure, hugging the index could be a good strategy. “Our advice to clients as well as in our portfolio positioning is, if you have to be in China, for example, China’s a big part of our index, then it is incorrect to own zero now, because valuation and positioning sentiment is so extreme.”
If sufficient policy support is in place to put economic growth on the table again, the sentiment could change again, and this swing comes along quickly. As Chinese stocks start to see signs of a rebound, Yeung says: “most portfolios around the world that have sold out the China position are going to re-visit their portfolios.”
Echoing the view, JP Morgan AM’s Hui says: “It is very difficult to sugarcoat the fact that sentiment right now is still very cautious on China’s onshore [market]. But at the same time, sentiment can change quite quickly.”
What’s Going to Happen to China’s Pending IPOs?
Other than policy, Hui adds another factor to watch – some well-received Chinese company IPO listings. He thinks: “We need domestic investors to feel more optimistic first. Then, that will convince international investors to get back into China.”
“If we start to see a few more household names in technology start to be able to list either in the U.S., in Hong Kong, or even back in China, I think that again will be important because, ultimately, that will signal that these companies’ managements feel that they are getting a better price or better valuations from the markets. That again will be an important signal of confidence for broader investors to get back into technology.”
Focus on Companies that Contain Costs, and Diversify and Grow
A term that has been around in the wellness space for years has now made its way to the corporate strategy meeting – ‘Self-Help.’
Ninety One’s Ma and Ernest Yeung, portfolio manager at T Rowe Price both emphasized the importance of “self-help” by companies. To explain this, Yeung split the group of Chinese technology names into two buckets – he thinks “both buckets are fairly interesting.”
1. The first bucket comprises companies that have made inroads into the international market. He gave two examples: e-commerce platform PDD Holdings (PDD) and gaming company NetEase Inc (09999, NTES).
2. The second bucket holds a number of companies that are engaged in streamlining costs to protect profit. The epitome of this is Tencent Holdings (00700).
Yeung says: “Companies recognize the fact that the domestic market is no longer fast-growing. They are engaging in a lot of self-help. For example, they are saving on cost, rationalizing their investment, and selling a lot of their non-core investments.”
“The investment thesis for that bucket is turning from growth into value. If they do the right self-help, the stocks can go up because they are no longer driving earnings from top-line revenue, but they are driving earnings from cost saving and rationalizing the investment portfolio.”
Also searching for companies that are “self-helping”, Ma says: “We would like to find companies in this cyclical inflection environment but also have the self-help to add that incremental structural growth element to it.”
Managers are Now Rotating out of Value
Other than tapping into cheap, cyclical names, Ma says having a “blended style” would help navigate through different style performance cycles. That means, on the portfolio construction level, she is looking at individual stocks and considering their impact on the overall style exposure to the risk of reward of the overall portfolio.
“Instead of value being the only investment style that worked, we start to see quality, earnings momentum, and price momentum make a difference and become meaningful performance drivers for share prices and for stock selections.”
As a stock picker, Ma is pleased to see a broadening rally across a handful factors. “And we think very much this kind of environment is likely going to continue into 2024,” she adds.
In the Ninety One portfolio, another opportunity is some cyclical growth names. “This is coming from the companies that have gone through very long destocking and earnings downgrade cycles that may be turning around at this point.” Examples include certain tech industries that inventory stockings coming to an end.
