Malcolm Dorson
Paul DmitrievChina, the second largest economy in the world, has been the worst performing market within the MSCI Asia Pacific Index since late 2020.1 Given the pessimism in the market, we believe Warren Buffet’s famous quote about investing is particularly apt and that 2024 presents an opportunity for stock pickers, as valuations grow disconnected from fundamentals. Though China may face uncertainties in terms of a U.S. election cycle and hawkish rhetoric from all parties, valuations appear discounted and fundamentals look to be improving. With MSCI China Index 2024 consensus earnings-per-share estimates projecting strong 14.2% growth and the market now being down for three consecutive years (not seen since the early 2000s tech bubble), we see room for a bounce.2 We believe it’s vital to look at these key points:
- Stimulus: Albeit slower than the market has desired, we have seen steady and proactive government support since the middle of 2023. Thus, we believe that signs of stabilization and growth should continue to emerge through 2024. In terms of consumption, we believe policymakers will focus on enhancing effective income while eschewing large-scale consumption vouchers, indicating a preference for more active fiscal policy with targeted distribution adjustments.
- Geopolitics: We were encouraged by the various meetings between senior level officials from China and the U.S. through 2023, culminating in a summit between President Xi Jinping and President Biden in November. We expect U.S. politicians to show more “bark than bite” through the 2024 election cycle, as tariffs have proven a challenge for U.S. inflation.
- Manufacturing & Trade: Though not in our base case, any signs of improving external demand for Chinese goods would likely translate into a significant tailwind for China’s economy.
- Property Sector: President Xi’s 2017 statement prioritizing housing for living, not speculation, signaled a shift in policy that many developers and investors didn’t fully acknowledge. There is still a significant supply for the market to digest, but we are encouraged by the proactive government measures to avoid spillover into other sectors. Broadly speaking, we’re also encouraged by the trend of Chinese households moving their savings out of real estate and into capital markets.
- Reopening: Though overlooked, we continue to see improving consumer confidence coming out of the delayed reopening from China’s severe lockdown period.
- Valuations: The MSCI China Index trades at an 8.8x price-to-earnings (P/E) ratio and 1x book value, which are more than one standard deviation below five-year historical averages.3
It’s important to also examine the message from the December Central Economic Work Conference (CEWC), which noted that economic activity had likely already hit its lowest point. However, policy makers indicated that challenges persist and that their work is not yet done. The CEWC outlined nine tasks, five of which we see as potentially important to market dynamics:
- Drive innovation and industry advancement, emphasizing the digital economy, AI technology, bio-manufacturing, aerospace, quantum, and life sciences.
- Stimulate domestic demand, creating a mutually reinforcing cycle between consumption and investment. Enhance social welfare and safety nets, particularly emphasizing employment for key groups.
- Uphold and implement the “two unswerving” principles: fortifying the public sector while supporting non-public economic development.
- Improve market access across telecommunications, medical, and other service sectors.
- Mitigate risks in critical areas like real estate, local government debt, and small- to medium-sized financial institutions.
We were also encouraged to see the National People’s Congress Standing Committee approve a mid-year expansion to the Central Budget this year – the first time since the 1998 Asia Financial Crisis.
Despite the government’s 2023 efforts to stabilize the economy, it often takes time for policies to translate into growth, and we anticipate impacts into the real economy through 2024. Monthly data should fluctuate, but fears concerning systemic risks have diminished, possibly resulting in the emergence of bottom-up opportunities. Thus, we are cautious on China from a broad perspective, but see many fundamental opportunities for stock pickers amidst the widespread pessimism.
Encouraging Recent Economic Data
- GDP rose 4.9% year over year in 3Q23.4
- The International Monetary Fund revised its 2024 China GDP growth forecast upwards by 40 basis points, to +4.6%.5
- The Consumer Price Index fell 0.2% in October and 0.5% in November.6
- Retail sales rose 10.1% YoY in November, the fourth straight monthly sequential acceleration.7
- Disposable Income per capita rose 5.9% in 3Q23, the third straight quarterly sequential acceleration.8
- Outbound passenger trips rose to 85% of 2019 levels during Golden Week in October.9
Government Policies Likely to Drive Markets in 2024
At the end of the day, the 2024 outlook for Chinese equities hinges significantly on the trajectory of government policies. We primarily see two potential scenarios:
- If policymakers double down on a robust fiscal policy, particularly in areas like affordable housing, we anticipate a positive ripple effect on consumer sentiment that could buoy consumer-oriented sectors, particularly in names that have de-rated to attractive valuations this year. This could also potentially invigorate cyclical sectors that typically benefit from an improved economic landscape – e.g., construction, real estate, and financial services could see a boost as housing policies drive related economic activities.
- On the other hand, should the policy emphasis shift towards a more muted fiscal approach, then our focus would remain on identifying sectors/alpha plays that are not highly dependent on cyclicals. For example, several opportunities in IT and artificial intelligence (AI) appear poised to continue their growth trajectory independent of broader cyclical trends, potentially offering alpha opportunities for investors seeking growth in less economically sensitive areas. We expect these sectors to benefit from global digital transformation trends and China’s commitment to technological self-sufficiency, likely making them attractive regardless of cyclical economic shifts.
In either scenario, a focus on quality and aligning investment strategies with nuanced policy shifts will likely be crucial in identifying opportunities that are primed to outperform.
Broadly speaking, we believe the government may support the Chinese Consumer (given the recent pain in the real estate sector and the government’s desire to double China’s middle class), Healthcare (given the aging population along with the struggles of recent lockdowns), and Information Technology (as the government steps towards independence from the West). We believe these sectors offer the most opportunities, as it’s vital for investors to align themselves with the goals of the Chinese Communist Party (CCP).
Easing Other Concerns:
- Can one invest in a country that isn’t a democracy? In our view, the leadership structure in China is counterintuitively geared toward capitalist ends. The CCP leadership prioritizes economic growth and evaluates its regional leaders on it. This encourages innovation, sometimes through healthy competition and other times by favoring leading players. Since the end of the Cultural Revolution, China has shifted away from traditional Marxism. Most sectors are now partially privatized, unlike when the government owned all factories and farms. However, the CCP still wields substantial control: major banks and domestic media remain state-owned, allowing leadership to influence loans and media content.
- Is the CCP anti market? No. China introduced its anti-monopoly laws in 2007, significantly later than the U.S. laws of the late 19th and early 20th centuries. Tech giants like Alibaba, Tencent, and Baidu were established before these regulations, allowing them to solidify their positions. For years, Chinese companies operated in ways that wouldn’t comply with U.S. and European standards. Recent steps up in regulation actually help China’s laws align with Western market norms, a move that can be viewed positively as an effort to catch up. Ultimately, they are trying to protect consumers and independent merchants. The Chinese government benefits from successful private companies in driving wage growth, common prosperity, and innovation.
- Is China too big to adjust? No. One of the byproducts of the power held by the CCP is that the country can change course when previous policies don’t work. These adjustments and improvements have played out in everything from shadow banking to electricity shortages.
Conclusion
Broadly speaking, China likely has an uphill battle in front of it in 2024, but the equity market should not be overlooked. We believe that the country will continue to digest headwinds in the form of property market weakness, a consumer in need of a larger safety net, and geopolitical uncertainty. However, these factors could also create valuation-based opportunities for longer-term contrarian stock pickers. China may be controversial and out of vogue, but it is also inexpensive and making some necessary adjustments. We think investors should be careful not to underestimate the impact policy adjustments can have on market sentiment and performance, as one of the counterintuitive aspects of investing in China is understanding that the power of the CCP allows for potential dramatic economic improvements.