In this Q&A, May Ling Wee from the China Equities Team comments on the key issues impacting China’s recovery post COVID-19 and stock market performance year-to-date.
- China-US relations have worsened since the emergence of COVID-19 with the resurfacing of trade, technology, and now potentially financial wars.
- The proposed National Security Law in Hong Kong may lead to tighter economic integration between China and Hong Kong. Hong Kong’s role as China’s gateway to foreign capital is likely to remain as it serves China’s best interests.
- China’s recovery, reflected in production indicators appears to be steady but domestic consumption is lagging the recovery in production, and external demand is weak, posing challenges for the overall economy.
- Opportunities remain in China’s consumer-facing businesses as companies adapt and develop new channels and revenue sources while driving at cost efficiencies. Infrastructure companies that have pricing power are an area of relative strength when domestic demand and from the rest of the world remain uncertain.
What is the current state of China-US relations?
China was the first country to enter lockdown on the onset of COVID-19 and the first out of lockdown, and the first on the road to economic recovery. But China-US relations have worsened since the emergence of COVID-19 as the country contends with the resurfacing of trade, technology, and now potentially financial wars with the US.
The commercial relationship between China and the US will continue to be tense, and there are multiple non-trade levers that the US may choose to pull. For example, enforcing wider controls on technology exports, rather than focusing on specific companies such as Huawei and others on the US Entity List (which are deemed to be acting contrary to the national security or foreign policy interests of the US). It includes broadening out restrictions to technology firms that supply to the Chinese government and military or trying to close loopholes where US companies that manufacture outside the US can bypass restrictions. In the long term, this only serves to increase China’s resolve to achieve independence in its technology supply chain.
How are new listing rules on US stock exchanges affecting Chinese companies?
Preventing companies that have Chinese majority joint ownership from listing on US stock exchanges is very topical, due to the recently passed US Senate bill that requires companies to comply with US regulatory audits or be forced to de-list from US stock exchanges. For Chinese companies already listed in the US, this is a medium term rather than immediate issue since there is a grace period of three years before delisting, and in practical terms delisting in the US is a complicated and long process.
It is unclear if the Chinese regulators are not allowing the inspection of company audit papers on the basis of ‘sovereignty.’ Many Chinese companies listed in the US are consumer-facing businesses with no state ownership or involvement and are not deemed politically sensitive by China. However, according to China’s regulations, companies are not allowed to show their audit work papers to a foreign regulator because the businesses they undertake occur in China.
As a backstop, Chinese companies are moving ahead in seeking a dual listing in the US and Hong Kong, as we have seen with Alibaba, NetEase and JD.com. The Hong Kong Exchange provides a viable alternative (although with lower trading volumes than US stock exchanges) for Chinese companies to access global capital and investors. The possibility of a delisting from US stock exchanges may result in investors demanding higher risk premiums for owning these stocks, but it does not detract from the fundamental attractiveness of many highly cash-generative Chinese businesses currently listed in the US.
Source: Getty Images.
What is the impact of the proposed National Security Law on Hong Kong and China?
The National Security Law allows for an extension of China’s political control in Hong Kong. It is possible that the deterioration in Hong Kong’s social and political backdrop could potentially drive a brain drain of Hong Kong citizens and residents over time. This is more likely to be a slow-moving process, therefore any associated capital outflows are unlikely to be immediate. On the contrary, there have been increasing capital flows from China into the Hong Kong market. Hong Kong’s economic integration with China will likely tighten further over time with an even larger representation of mainland companies on Hong Kong’s stock exchange, the flow of talent from the mainland continuing and an increased likelihood of more Chinese companies taking a larger role in Hong Kong’s corporate sector.
Hong Kong has long been an international financial centre and a place for Chinese companies to raise capital. This role is unlikely to change as long as Hong Kong continues to be able to process and settle US dollar transactions/trades. It is in China’s interests for Hong Kong to maintain this role, as China’s capital account is still closed and at present, Shanghai or Shenzhen cannot replace Hong Kong as China’s financial centre. An extreme outcome would be for the US Federal Reserve to stop US dollar settlements with some banks in Hong Kong or with the Hong Kong Monetary Authority (HKMA). This would mean the Hong Kong/US dollar peg may be hard to operate. Should Hong Kong face such sanctions from the US, its function as a global financial centre is likely to diminish.
What is China’s recovery looking like?
China’s recovery, reflected in production indicators post lockdown, appears to be steady as factories caught up on orders missed during the shutdown. However, consumption activity, especially in services, still remains below 2019 levels. This is largely due to the requirement for social distancing and fear of infection but also because of the weaker macro environment and lower income expectations of the Chinese consumer. To date, the real estate sector has held up well in terms of home buyer sales and investment by developers. Infrastructure investment declined in the first quarter of 2020 due to the shutdown. On the ground, there are now indications of a strong pickup when looking at cement, construction machinery and heavy-duty trucks sales. An uplift in infrastructure activity is expected in the second half of the year, following two years of low single-digit growth. This will be supported by funds raised via special purpose local government bonds and the central government’s special COVID-19 treasury bonds.
Deteriorating China-US relations in the wake of COVID-19 resulted in China initially being viewed as a strategic rival but now to almost being viewed as an enemy. At present, it does not appear that China will meet the requirements of the phase one trade deal in terms of import volumes from the US due to China’s lower domestic demand. However, it is unlikely that this will result in tariff escalations because neither side can afford such moves during a period of global economic weakness. Recently, China has increased purchases of agricultural products from the US, continuing efforts to open up its markets.
Chinese firms and multinationals are likely to continue to diversify their supply chains by building manufacturing bases outside of China, in addition to their local factories to meet domestic demand. This process has already been occurring in the lower value manufacturing sector but COVID-19 and the consequences of concentrating manufacturing in one location will be evaluated by many firms. China needs to increase higher-value manufacturing (where it remains competitive) and continue to provide market access to foreign service providers. Post-COVID, the time taken by China to restart and see a pickup in industrial and manufacturing activity was faster in comparison to many other parts of the world. Despite concerns around the concentration of supply chains, many multinationals acknowledge that China has an advantage because it can offer a total supply chain, and there is a lack of strong viable alternatives now.
How have Chinese equities fared year-to-date?
The offshore market (MSCI China Index) and onshore market (CSI300 Index) are down 1.5% and 3.5% year-to-date (to 15 June) in US dollar terms*. Both offshore and onshore China markets have outperformed developed markets (with the exception of the Nasdaq) and emerging markets.**
The macro environment has been challenging for China. First with the COVID-19 pandemic, the current partial recovery in domestic demand and now weaker demand for China’s exports. Second with the technology and financial war with the US resurfacing, and third, the proposed Hong Kong National Security Law is clearly not helping relations between the two nations. But in its favour, China was the first to emerge from lockdown, and is on an easing path in terms of both monetary and fiscal policy (although on a more muted scale versus some developed countries). We have also seen resilience from China’s large internet companies, with some proving stronger as a result of the pandemic. Stock market performance has been largely driven by higher valuations especially among growth and quality stocks (non-financials) year-to-date. However, as the macroeconomic environment is expected to be weak through the course of the year, this is likely be reflected in further earnings revisions.
Many of China’s consumer-facing businesses have been impacted by COVID-19, resulting in headwinds for revenues and profits. However, there remain opportunities as many of these companies are adapting to a post-COVID environment, seeking new ways and sales channels to do business and driving cost efficiencies. The infrastructure sector, in particular those where companies have pricing power, can be an area of relative strength when Chinese demand and from the rest of the world remain uncertain.
*Source: Bloomberg. MSCI China Index and CSI 300 Index (in US$ terms) year-to-date price returns to 15 June 2020. Past performance is not a guide to future performance.
**Source: Bloomberg. MSCI China Index, CSI 300 Index, MSCI Developed Markets Index and MSCI Emerging Markets Index, year-to-date US$ price returns to 15 June 2020. Past performance is not a guide to future performance.
China onshore and offshore market: onshore stocks are those listed on the mainland Shenzhen and Shanghai stock markets, while offshore refers to Chinese stocks listed on Hong Kong, US or other overseas bourses.
Pricing power: the ability to raise prices without reducing demand for products or services. More pricing power makes it easier to raise prices.
Monetary policy: actions of a central bank aimed at influencing the level of inflation and growth in an economy. Monetary easing refers to increasing the supply of money and lowering borrowing costs.
Expansionary fiscal policy: steps taken by a government to influence economic conditions by increasing government spending and/or reducing taxes.
Growth stocks: stocks/companies with strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Quality stocks: stocks/companies that have the potential for higher profitability, have demonstrated steady business performance over time and financial strength enables long-term investment into the company.
National Security Law: a proposed law by China banning all seditious activities aimed at toppling the central government and external interference in Hong Kong’s affairs, as well as terrorist acts. Hong Kong citizens are concerned that the law would curb their rights and freedoms. Hong Kong was handed back to China from British control in 1997, but under a unique agreement known as the ‘Basic Law’ and a so-called ‘one country, two systems’ principle. The Basic Law is meant to protect certain freedoms for Hong Kong such as freedom of assembly and speech, an independent judiciary and some democratic rights.
Capital account: is a record of the inflows and outflows of capital that directly affect a country’s foreign assets and liabilities. This encompasses foreign investment and loans, banking and other forms of capital, as well as monetary movements or changes in the foreign exchange reserve. China has a closed capital account; companies, banks and individuals are not allowed to move money in or out of the country except in accordance with strict rules.
US Entity List: a US Department of Commerce published list of foreign individuals, businesses and organisations that are subject to specific license requirements for the export, re-export and/or transfer (in-country) of specified items.