Market Views: How will China's zero-Covid policy affect equities?

Market volatility is likely to remain high as investors try to figure out the duration and severity of lockdowns. Stocks with attractive valuations may start to outperform in the second half of 2022.
Market Views: How will China's zero-Covid policy affect equities?

Market observers see China’s Covid zero policy and the lockdowns in place across the country as the biggest near-term risk to economic growth in 2022.

Of the country's tier-one cities, Shanghai and Beijing are still under lockdown, though different conditions apply to each, while Shenzhen and Guangzhou have just come out from theirs. Other cities are also struggling in their zero-Covid fight.

The restrictions contributed to the services sector slumping to its weakest level in more than two years in April, with the Caixin services purchasing managers' index (PMI) falling to 36.2, down from 42 in March, Thursday (May 5) data showed. This is the second-lowest number since the survey began in November 2005, only the 26.5 figure in February 2020, near the start of the pandemic was lower. A reading under 50 suggests contraction. 

Weak import growth and sharp declines in passenger and freight traffic volumes are other signs of the economic slowdown.

It is no surprise then, that onshore and offshore Chinese equities are trading below their 15-year average on a price-to-earnings and price-to-book ratio basis.

China is unlikely to change its zero-Covid policy, at least not before the 20th National Congress of the Communist Party of China later this year. Against this background, AsianInvestor asked fund managers how the approach will further affect the performance of Chinese equities this year and beyond, and where opportunities lie.

The following contributions have been edited for clarity and brevity.

Jason Liu, head of CIO office Asia
Deutsche Bank International Private Bank

Jason Liu

Recent Omicron infections in Shanghai and many more cities do pose downside risks to growth in the near term, but we see a gradual easing in infections and more reopening going into H2. We believe Chinese equities could show outperformance later this year on the back of a recovery in economic growth, attractive valuations and policy stimulus. That said, once the Covid-19 restrictions are lifted, a lot will also depend on how quickly supply chain disruptions can be resolved. Downside risk to our base case will be if supply chain disruptions are not resolved in a timely manner.

The longer-term impact around the shifting of supply chains from China could remain limited, in our view, particularly if the virus recedes gradually in the coming months. In recent weeks, local governments have been already reopening factories to minimise supply chain disruptions. In the longer term, China remains a large and growing consumer market. Many production activities need to stay in China to cater to domestic needs.

Overall, Chinese equity markets continue to trade at a significant discount (12-month trailing P/E ~10x for CSI 300) versus the US (S&P 500) at ~19x and Eurozone (Euro Stoxx 50) at ~13x. We expect fixed investment growth from different sources to pick up pace in H2 2022: manufacturing investment as well as public investment in infrastructure, innovation/research, and development, and “green investment”, boosting domestically oriented companies in sectors like consumer, industrials, real estate and ESG.

At the same time, we also watch regulatory developments in the technology space particularly closely for clarity and look to tactically accumulate H-shares given the steep valuation discounts available right now (HSCEI Index is down ~42% from March 2021 high).

Ferdinand Cheuk, portfolio manager
Templeton Global Equity Group

Ferdinand Cheuk

China’s Covid zero policy continues to pose a headwind for both Chinese equities and global growth. The impact can be seen in volatile equity markets, reflecting concerns around lockdowns, travel restrictions and interruptions to industrial capacity. Longer-term impacts may be felt if trading partners shift businesses towards countries with fewer restrictions. Consensus figures for Chinese economic growth have decreased but some of this may be tempered by accommodative policies outlined by the People's Bank of China (PBOC). This, in conjunction with language suggesting a possible easing of regulatory measures, should provide a positive tailwind for Chinese companies in contrast to the tightening measures seen across several other global markets.

The erratic nature of pinpointing outbreaks within China makes it difficult to identify any meaningful beneficiaries from the current environment. However, while both domestic and export sectors have been impacted by Covid, opportunities lie in the eventual recovery of consumption demand and normalisation of the supply chain. Sectors benefitting from long-term themes such as domestic consumption and localisation should remain favourable, given the depressed valuations at which they are trading.

Michele Barlow, head of investment strategy and research, Apac
State Street Global Advisors

Michele Barlow

Market expectations are for the zero-Covid policy to remain until the latter part of the year, but, in reality, it will depend on how quickly China can increase vaccination, make therapeutic oral drugs broadly available and ensure there are enough facilities available and ready to support an increase in cases. Therefore, a focus on progress is important.

Market volatility is likely to remain high as investors try to determine the duration and severity of lockdowns. Sectors most directly impacted will continue to be those affected by weaker consumer sentiment such as travel, retail and restaurants. Manufacturers may be indirectly impacted by short-term shutdowns or due to the inability to get input supplies but should bounce back on re-opening.  Policymakers are not backing away from the 2022 growth target. The Politburo economic meeting signalled a clear “stepping up” of targeted policy stimulus which should see China’s credit impulse rise.

Despite these near-term market gyrations, longer-term trends remain in place including economic growth and rising consumption, technology-enabled transformation of industries, the rise of local brands, and supply chain localisation. And valuations are now low on a historical basis, having moved lower despite a steady and broadening earnings base with the current 12-month forward P/E at 9.7 (versus 12.0 in April of 2019). Therefore, China can play a meaningful role in global asset allocations, but we recommend taking an active approach.

Jessica Tea, senior investment specialist, Greater China equities 
BNP Paribas Asset Management 

Jessica Tea

The biggest near-term risk to Chinese growth is its dynamic zero-Covid policy, which is offsetting the positive effects of Beijing’s cautious policy easing. Though the credit impulse is rising as the PBOC eases policy incrementally, China needs to focus on easing policy to boost sectors it has effective control over – i.e. reviving the housing sector to boost construction and accelerating state-led infrastructure investment.

Our China equities team prefers to focus on the defensive and policy beneficiaries and avoid those subject to higher geopolitical risk. We remain opportunistic at the stock level, favouring companies with strong pricing power mostly related to industrial upgrading and energy transition. 

Lorraine Tan, director of equity research, Asia

Lorraine Tan

Our base case view remains that the bulk of the material lockdowns and any disruptions will be seen in this 2Q. We expect risks to reduce in the 3Q and recovery in the 4Q. We also expect the government to announce more supportive measures once daily Covid cases have peaked. Again, we think this will coincide with the 3Q.

If there is risk from a more prolonged Covid disruption, we think we would avoid the consumer staples and discretionary names in particular, given rising input costs as they may be an added drag on margins.

Tai Hui, Asia chief market strategist
JP Morgan Asset Management

Tai Hui

Although 1Q 2022 GDP has shown that the Chinese economy began to rebound in January and February, this would be overshadowed by the pandemic’s impact on consumption, investment and production. We believe a decline in new infection numbers will be the first step in improving market confidence. With part of the population in lockdown, fiscal and monetary stimulus may not be fully effective at this point.

Overall, the best-case scenario is that China has a V-shaped recovery starting in late 2Q or early 3Q. We don’t think the Chinese authorities will deviate from its zero-Covid approach, although there could be some adjustment in coordination amongst different ministries as well as different regions. President Xi also emphasised the need for infrastructure investment to support economic growth. That could provide some much-needed impetus for market sentiment.

A significant number of challenges are reflected in prices, and they need a spark to rekindle market sentiment, especially as we approach the 20th Party Congress later in the year. Market stability as the Federal Reserve provides more clarity and China’s recovery from the current Covid wave should help investors feel more confident about taking advantage of these opportunities. 

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