China: Moderation Expected After a Steady Early Recovery

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.

Key Takeaways

  • China-U.S. relations have worsened since the emergence of COVID-19 with the resurfacing of trade, technology and – more recently – potential 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, as reflected in production indicators, appears to be steady. However, 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 toward cost efficiencies. Infrastructure companies that have pricing power are an area of relative strength when demand – both domestically and from the rest of the world – remains uncertain.

What is the current state of China-U.S. relations?

China was the first country to enter lockdown at the onset of COVID-19. It was also the first country to emerge from lockdown and therefore the first on the road to economic recovery. But China-U.S. 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 U.S.

The commercial relationship between China and the U.S. will continue to be tense, and there are multiple nontrade levers that the U.S. 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 U.S. Entity List (which includes those firms that are deemed to be acting contrary to the national security or foreign policy interests of the U.S.). Other actions may include broadening restrictions to technology firms that supply the Chinese government and military or trying to close loopholes where U.S. companies that manufacture outside the U.S. can bypass restrictions. In the long term, these tactics only serve to increase China’s resolve to achieve independence in its technology supply chain.

How are new listing rules on U.S. stock exchanges affecting Chinese companies?

Preventing companies that have Chinese majority joint ownership from listing on U.S. stock exchanges is very topical due to the recently passed U.S. Senate bill that requires companies to comply with U.S. regulatory audits or be forced to delist from U.S. stock exchanges. For Chinese companies already listed in the U.S., this is a medium-term rather than immediate issue since there is a grace period of three years before delisting. In practical terms, delisting in the U.S. is a complicated and long process.

It is unclear whether Chinese regulators are not allowing the inspection of company audit papers on the basis of “sovereignty.” Many Chinese companies listed in the U.S. 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 their businesses are based in China.

As a backstop, several Chinese companies are moving ahead in seeking a dual listing in the U.S. and Hong Kong, as we have seen with Alibaba, NetEase and The Hong Kong Exchange provides a viable alternative (although with lower trading volumes than U.S. stock exchanges) for Chinese companies to access global capital and investors. The possibility of a delisting from U.S. 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 U.S.

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, so 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 center 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 U.S. 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 center. An extreme outcome would be for the U.S. Federal Reserve to stop U.S. dollar settlements with some banks in Hong Kong or with the Hong Kong Monetary Authority (HKMA). This would mean the Hong Kong/U.S. dollar peg may be hard to operate. Should Hong Kong face such sanctions from the U.S., its function as a global financial center 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 have caught up on orders missed during the shutdown. However, consumption activity, especially in services, still remains below 2019 levels. This is largely due to social distancing requirements 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 truck 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 COVID-19 treasury bonds.

Deteriorating China-U.S. relations in the wake of COVID-19 resulted in China initially being viewed as a strategic rival to now being viewed almost 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 U.S. 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 U.S., 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 compared 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 (as of June 15) in U.S. dollar terms.1 Both offshore and onshore China markets have outperformed developed markets (with the exception of the Nasdaq) and emerging markets.2

The macro environment has been challenging for China for several reasons, first and foremost the COVID-19 pandemic and the current partial recovery in domestic demand and now the weaker demand for China’s exports. The resurfacing of the technology and financial war with the U.S. poses another challenge, while the proposed Hong Kong National Security Law is clearly not helping relations between the two nations. In its favor, however, China was the first to emerge from lockdown and is now 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 year to date has largely been driven by higher valuations, especially among growth and quality stocks (non-financials). However, as the macroeconomic environment is expected to be weak through the course of the year, this is likely to 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 (particularly those companies that have pricing power) can be an area of relative strength when demand – both domestically and from the rest of the world – remains uncertain.

1Bloomberg. MSCI China Index and CSI 300 Index (in US$ terms) year-to-date price returns to 6/15/20. Past performance is not a guide to future performance.

2Bloomberg. MSCI China Index, CSI 300 Index, MSCI Developed Markets Index and MSCI Emerging Markets Index, year-to-date US$ price returns to 6/15/20. Past performance is not a guide to future performance.

The MSCI China Index is constructed based on the integrated China equity universe included in the MSCI Emerging Markets Index, providing a standardized definition of the China equity opportunity set.

The CSI 300 Index consists of the 300 largest and most liquid A-share stocks. The Index aims to reflect the overall performance of China A-share market.