Chinese and Asian markets are evolving rapidly and require first-hand, local knowledge
Frantic buying after panic selling in mid-March reflected the complicated reality of Chinese equities.
On the one hand, investors turned especially cautious due to a cascade of negative news headlines. Renewed COVID outbreaks across the nation and delisting risks of U.S.-listed Chinese companies, for example, are well-known to the market but tested investors’ nerve again. Other news, such as the Federal Reserve rate hikes and the Russia-Ukraine war, should have had limited direct impacts on China.
On the other hand, many Chinese new economy companies have dropped 50%-60% since their peaks, making them attractive long-term investments due to their discounted valuations and their representation as the most promising part of the future of the Chinese economy. Some reassurance from the Chinese regulator on March 16 induced a relief rally of over 20% in two days, reflecting how depressed the market sentiment was and how quickly the sentiment turnaround could arrive.
After falling about 50% from its peak in February 2021, the MSCI China Index’s forward P/E ratio dropped to as low as 8.4x on March 15, significantly below a 10-year average of 11.3x. The deep discount indicates that Chinese equities are cheap in a historical context. Hence, we believe that even if it may not be time to turn bullish yet, fears are overdone and hopes start to build.
To have a deeper understanding of the market environment, we analyze six major risk overhangs and see whether an inflection point is approaching.
Chinese ADR delisting risks
The mid-March market sell-off was primarily triggered by fears of Chinese stocks being removed from U.S. bourses. U.S.-listed Chinese shares, often referred to as American Depositary Receipts (ADRs), contributed to the majority of trading volume of these companies even though some are dual listed in Hong Kong. On March 10, the U.S. securities regulator said it had identified five Chinese ADRs facing delisting if the companies failed to comply with auditing rules in the U.S. The audit disclosure requirement issue has been negotiated between the U.S. and China for years and is familiar to investors. Funds and indices have been shifting to shares in Hong Kong as a precautionary measure. Whether the delisting will materialize depends on the negotiation between regulators. Nevertheless, the market may have overreacted as China is willing to talk and, in the worst-case scenario, delisting will not take place until 2024.
Regulatory scrutiny on China internet
Besides pressure from U.S. regulators, Chinese internet companies also face domestic regulatory scrutiny. A Wall Street Journal article reported China’s communication services giant is subject to a potential record fine for anti-money-laundering violations. Shares of the company dropped 10% and more than US$40 billion of its market capitalization was wiped off in one day due to the report. It shows how sensitive the market is to China’s ongoing regulatory campaign targeting on issues such as anti-monopoly and social equality. Yet from another perspective, the extremely bearish market sentiment at the time was also a sign of the bottom.
There was indeed a V-shaped rebound on the following day after China’s Vice Premier Liu He, who is in charge of economic policies and financial issues, addressed recent market concerns. He vowed to keep good communication with U.S. regulators on potential ADR delisting, support Chinese companies’ overseas listings, conduct transparent and predictable regulatory oversight on platform economies (mainly referring to Chinese internet companies), carry out proactive monetary policies, mitigate risks in the property sector, and strengthen coordination with Hong Kong’s financial market. Liu assured investors that regulators would coordinate with the Financial Stability and Development Committee under the State Council before rolling out any policies that are influential to the financial market. His open support soothed market concerns on the issues that have been weighed on both onshore and offshore Chinese capital markets for the past year and marked an inflection point for Chinese equities.
Liu’s reassurance reminds investors of his market comments on October 19, 2018, when he reiterated China’s unwavering support for the private sector. His words in 2018 boosted investor confidence and eventually helped China’s stock markets bottom out.
This time, shares of the communication services giant were encouraged and bounced back by more than 23% in a single day. Other Chinese internet companies’ shares surged by double digits too.
Separately but simultaneously, China’s Ministry of Finance said it would not expand the property tax pilot program this year. The message alleviated concerns in the faltering property market and signals that China is mulling more market-friendly policies.
Zero COVID strategy
Another challenge facing the Chinese economy is the pandemic and China’s determination to contain it. Resurgence in COVID-19 cases has prompted strict pandemic-control measures in major cities such as Shanghai and Shenzhen since early March. However, as most of the cases are not critical, both cities managed to resume work and production as soon as possible in at least some areas.
There are early signs that China would fine-tune its strategy to combat the more infectious but less fatal Omicron variant. China’s President Xi Jinping on March 17 vowed to achieve maximum COVID prevention effects with minimum costs to the economic and social development. Two days earlier, China’s National Health Commission tweaked its COVID-19 diagnosis and treatment protocols to shorten hospitalization or quarantine period for those with minor or no symptoms. Although “live with COVID” is still hardly an option in the near term, the country’s top officials have realized that the Zero COVID strategy is increasingly costly. Any relaxation of the zero tolerance strategy later in the year will benefit economic growth and lift investor confidence.
Easing policies to stabilize the economy
The recent wave of COVID-19 tends to hinder China’s capability of meeting its annual GDP growth target this year. The growth target at “around 5.5%” has already been beyond investors’ expectations. The Bloomberg market consensus shows China is only able to grow its economy by 5.1% this year. To accomplish its target, the Chinese government needs to ramp up more supportive policies.
Further rate cuts coupled with other targeted monetary and fiscal policy measures are likely to be implemented in the upcoming months. As China’s Premier Li Keqiang said in this year’s Government Work Report, financial institutions are encouraged to lower real loan interest rates and cut fees.
Fed tightening and potential policy missteps
In contrast to China’s easing pivot, the Fed has just launched a new rate hike cycle with 25 basis points interest rate increase in the March Federal Open Market Committee (FOMC) meeting. The Fed would tighten monetary policies more aggressively if high inflation persists. Meanwhile, the U.S. economic growth is expected to slow quarter by quarter this year. The market is concerned about a hard landing of the U.S. economy due to policy missteps of the Fed. A flattening Treasury curve has suggested increasing probability of recession.
The pace and magnitude of Fed rate hikes depends on how long high inflation will last. Before there are signs of abating inflationary pressures, hawkish comments from Fed policymakers will continue to weigh on market sentiment. The good news, however, is that investors have already priced in a very bullish scenario of U.S. rate hikes. In addition, impacts of Fed monetary policies’ on Chinese equities are manageable.
The Russia-Ukraine war
Part of the Fed’s inflation problem is owing to the Russia-Ukraine war. And the market has been increasingly focusing on the war’s by-products – a commodity shock and geopolitical implications.
Sanctions on Russia have pushed up global oil and gas prices. Destroyed and abandoned farmlands in Ukraine threaten global food security. So far, consumer price inflation in China is moderate and not a risk. Meanwhile, market analysts expect U.S. CPI inflation to peak in the first quarter of this year at 7.7% and fall quarter by quarter thereafter until reaching 4.5% by the end of the year. If the expectation materializes, market jitters for U.S. stagflation will start to alleviate as early as the second quarter. Otherwise, investors need to prepare for more market volatility.
On the other hand, geopolitical implications of the war could be profound. China is trying to strike a balance between Russia and the West, and be mindful to not violate sanctions against Russia. At all events, fears of a Russian-style China-West decoupling are exaggerated even in a worst-case scenario. China is far more important and integrated in the global economy than Russia. Overlooking all investment opportunities in the world’s second largest economy is unrealistic.
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