Easing China uncertainty to drive Asia ex-Japan equity returns in 2023

After a difficult year for Asian stock markets, there is some thawing of investor sentiment towards the region in recent weeks. The Hang Seng rallied significantly in November. The catalyst consisted of an improving outlook for China with some moderation in the Government’s tough zero-Covid policy.

Asian markets have been dragged lower this year in response to the uncertainty in China. While India has performed well, amid structural reform and stronger economic growth, it has not compensated for Chinese weakness.

China’s zero-Covid policy has imposed significant restrictions, but it has not been the only concern for investors. There have been problems in the property sector, with the failure of indebted-developer Evergrande. There have also been concerns over President Xi’s consolidation of power, plus a regulatory crackdown and significant deterioration in US-Sino relations.

However, a lot of this bad news is already priced into Chinese stock market valuations. If there is some easing of the zero-Covid policy and signs that the country is starting to open-up, it could have a significant impact on both global and regional growth. Releasing of pent-up demand in China could compensate for weaker performance in the developed world. Equally, if the US dollar starts to weaken and the Federal Reserve pauses on raising interest rates, capital may start to flow from the US to Asia and China, and particularly into sectors such as global miners, oil and gas, and luxury goods.

A number of risks remain for China: the property sector is still around a quarter of Chinese GDP. The Government has tried to move money away from speculative areas such as real estate, to more productive areas of the economy, such as IT hardware. However, the zero-covid policy has precipitated a complete collapse in consumer confidence, which has also dented confidence in the housing market. Policymakers have stepped up support for the real estate sector, with interest rate cuts, home buyer tax rebates and targeted lending. The real risk here is the policy doesn’t work while consumer sentiment is so weak. Also, China’s demographics are not favourable for home-buying over the long term.

Another concern is Chinese politics. The recent communist party reshuffle handed President Xi a third term and created a new standing committee filled with Xi loyalists. This initially prompted a sell-off in Chinese markets as investors worried that China was prioritising ideological objectives over economic growth.

There is a more positive spin. The new committee has retained the strategic objective to reach medium-level developed country GDP per capita levels by 2035. That implies 4.7% annualised growth. The new premier, set to be sworn in early next year has a strong business-friendly background. Equally, a committee of Xi’s allies may see less in-fighting and more technocratic government.

Further regulatory crackdowns associated with China’s common prosperity project are also a risk. There were sharp crackdowns in 2021 as the Government became concerned on Alibaba and Tencent’s involvement in the financial sector. Nevertheless, there seems to be a move towards a more pro-growth agenda in the Government’s objectives for next year. This makes further curbs less likely.

The most significant risk is around US-Sino relations. In the CHIPS and Science Act, passed in August, the US brought in new controls on chip exports, including barring companies from exporting chip manufacturing tools. There is bipartisan support in the US for ensuring China no longer has access to US technical know-how.

At the same time, China knows it has lost its labour dividend. Its working age population is starting to shrink. It really needs to move up the value chain with significant productivity gains if it is to meet its GDP growth objectives.

There has been an earnings recession, which is not surprising, but the outlook for earnings is more encouraging. There is likely to be a rebound in 2023 and 2024, consistent with China opening up from lockdowns. At the same time, valuations across Chinese stock markets are the lowest of all major countries except the UK. It is also much cheaper than its long-term average. This suggests a lot of negative news is already in the price.

There are a number of potential catalysts. A loosening of Covid restrictions could lift consumer and investor confidence. There is a clear message from central Government that it wants to open up. Vaccine rates need to be higher, but there are signs of improvement. Bank credit is readily available if manufacturing fires up again. A final catalyst may be a weakening US dollar, as a result of a pickup in global growth expectations. This could prompt investors to reallocate to Asia.

It has been a tough time for investors in Asia, but the outlook for China looks brighter in the year ahead and valuations are more compelling. Risks remain, but these appear to be well-understood by investors.