Market Views: What will it take to reverse capital outflows from China?
There was a massive drain of foreign capital from emerging markets in March, with China setting record outflows for both equities and bonds.
Foreign investors sold $11.2 billion of Chinese bonds and $6.3 billion of stocks in March – marking the first major stock selloff since the technology crackdown in September 2020, according to the Institute of International Finance.
The capital outflows are triggered by a mix of negative factors. They include: China’s growth slowdown, delisting risks of American depositary receipts (ADRs), the impact of zero-Covid policy lockdowns on the economy, and ongoing regulatory crackdowns. The prolonged Russia-Ukraine crisis is piling more pressure on fund managers concerned about their China exposure.
Meanwhile, as the Federal Reserve ramps up its rate-hike cycle, the yield premium of 10-year Chinese government bonds (CGBs) over comparable US Treasuries turned negative on April 11 – a first since June 2010.
Global funds have withdrawn almost 90 billion yuan ($14 billion) of CGBs in the past two months as yield advantage faded, according to Bloomberg. Currently, 10-year CGB yields around 2.86%, just shy of US Treasury’s 2.87%.
Meanwhile, investors take no comfort from China’s stronger-than-expected Q1 GDP of 4.8% as long as the Ukraine war and the lockdown in Chinese cities persist. This week, AsianInvestor asked fund managers what it would take for investor confidence to return to China, and how investors should position themselves in this challenging period.
The following contributions have been edited for clarity and brevity.
Alan Wang, portfolio manager
Principal Global Equities
We heard that foreign investors have been responsible for the recent equity outflows from China in search of opportunities elsewhere. However, as Principal stays focused on pension funds and long-term investors, we received significant inflows in the first quarter this year - to do bottom-fishing - which is more than the previous quarter. These are mostly from existing clients, specifically pension money.
China is currently the only major economy in the world that has both expanding monetary and fiscal policies and attractive valuations below long-term average. While the MSCI China Index is expected to generate 10% earnings growth this year and 16% next year, it trades at 9.1x next year price–earnings (PE) ratio, 1x standard deviation cheaper than 10-year of average of 10.6x.
Recently, many investors have turned risk-averse on China - deeming it as the next sanction target after Russia, post the Russia-Ukraine war - we believe, however, it’s purely a recency bias and should not impact the long-term prospects for equity growth in China. We would be surprised if China shows extreme action in favor of either Russia or Ukraine. Sanctions could add more pressure to inflation, while China’s resilient export growth, up 16% year-on-year in the first three months this year (USD terms), is a good indicator of real global demand.
The imminent threat to Chinese corporate earnings is the “Covid-Zero” policy which is depressing domestic discretionary consumption, logistics, and manufacturing. We believe Hong Kong’s data and experience dealing with the fifth wave of Covid can lay a solid ground for mainland China’s open-up scenario, which may lead to economic recovery.
Looking forward, with an abundance of external geopolitical risks and internal challenges, we expect the government to release more supportive measures than tightening policies, as historically China has never failed to reach its GDP growth target in a year of government reshuffling.
Robert Secker, portfolio specialist
T. Rowe Price
The Chinese government is sending a consistent message that it understands the market concerns and is trying to address them one by one with more concrete actions. The market is also hoping to see more reserve cuts and policy rate cuts from China to boost the real economy.
Despite that near-term economic indicators may show some weakness, we believe China is in a better position to provide more fiscal and monetary easing compared to other major economies due to well-controlled consumer price index (CPI) inflation.
We do not take a big bet on policy moves but we believe that more market-friendly actions from the government will be beneficial to active managers like ourselves. As market confidence is restored, more investors will likely refocus on the fundamentals, and we believe conducting bottom-up analysis is still the best way to generate sustainable alpha in China.
After the selloff this year, we believe China is subject to lower selling pressure than before. We have seen a similar selloff in 2018 when the US initiated a trade war with China. The market was extremely bearish on China back then, but history has informed us that Chinese equities bounced back strongly afterward.
We continue to monitor risks related to new Covid variants and geopolitical tensions as they often present great buying opportunities for long-term investors. We have been taking advantage of the recent volatilities to add to quality businesses that used to be too expensive to hold. The valuation of many Chinese equities has become more compelling and many of them are trading at a discount compared to their global peers.
Hyde Chen, managing director and head of investment strategy
Haitong International Asset Management
After weeks of large foreign de-risking in March, flows have stabilised and turned two-way recently. However, for asset prices to continue rebounding, investors likely need to see how the recent Covid-19 outbreak pans out in China, how property credit risk will be resolved, will the US issue new sanctions on Chinese companies, and whether policy support is able to keep the economy and corporate earnings ticking over.
On these points, we remain sanguine about Beijing’s determination to reach its economic growth target and engineer a soft landing for the property sector. The turning point for the market could come around mid-year as the aforementioned risks fade and policy easing starts to take effect, although investors should brace for a volatile path ahead.
As such, we maintain a small overweight position on China A-shares in our tactical asset allocation as we believe room for further valuation de-rating is limited while the market is expected to deliver double-digit earnings growth over the next 12 months. The onshore market is also more sensitive to the government’s policy stimulus.
Moreover, broad Asia high-yield bonds currently offer mid-teens percentage effective yield. While property sales in China will likely take a few more months to bottom out, we expect policy support to continue, even as the market is pricing in heavy default risks after sizable corrections since mid-2021. The worst is probably behind us, however, investors need to remain very selective in Asia high-yield.
Michele Barlow, head of Asia Pacific investment strategy and research
State Street Global Advisors
We believe that there needs to be more stabilisation at the macro level in the near-term to help steady investment flows. While China’s GDP forecast came in above expectations for 1Q at 4.8% year-on-year, economic indicators have been weakening.
China’s dynamic zero-Covid policy has seen increased lockdowns across the country and more recently authorities imposed a strict citywide lockdown in Shanghai. This has led to broad-based disruption for transportation with Shanghai as one of the largest ports and is starting to impact consumer behavior and business confidence.
While the People's Bank of China recently implemented a bank reserve requirement ratio (RRR) cut of 25 basis points, the move disappointed markets which were expecting more aggressive policy action.
Over the longer term, we would expect to see investors return to the Chinese stock and bond markets. Although the yield differential between 10-year US Treasuries and China government bonds has closed with both trading at similar yields, the real yield differential remains wide with still quite negative yields in the US compared to positive yields in China.
Chinese bonds can also provide strong diversification benefits in a portfolio given their low correlation to other global bond markets. Chinese stock valuations are looking quite attractive relative to other markets and Chinese stocks can also provide decent diversification in global equity portfolios.
However, near-term confidence and earnings are likely to remain under pressure as long as growth uncertainty remains. This is where an active strategy can be beneficial. Longer-term, we still believe China can play a meaningful role in global asset allocations.
David Chao, global market strategist, Asia Pacific ex-Japan
Invesco
The GDP print for Q1 came in stronger than expected, but the market is expecting a slowdown that could last beyond Q2, so we may well see additional policy support beyond the latest RRR cut, perhaps in loan prime rates. While the property market hasn’t reached a clear trough and geopolitical issues remain unresolved, it’s China’s Covid response that remains the key near-term variable affecting investor sentiment which remains stubbornly risk-off.
The relentless outbreak of the Omicron variant in Shanghai and across the country has, to now, pushed Chinese authorities to double down on their zero-Covid policy. This could lead to further supply chain pressures and sap consumer spending.
We are seeing some efforts to allow production to restart in closed-loop arrangements, for example in critical sectors such as automotive, which could be a positive catalyst for consumer sentiment. Any progress in approving and distributing a home-grown mRNA vaccine will also be welcome news.
Most assets are still finding their footing in this market, including Chinese government bonds which are seeing their yield premium over US Treasuries evaporate due to divergent monetary conditions. High-quality, RMB-denominated corporate credit in policy-friendly sectors may be better in this environment.
China’s trade surplus is a key structural advantage that should keep the RMB outlook relatively stable against the USD. Investors may also find opportunities in debt issued by financially sound local government financing vehicles, with a careful focus on credit selection.