China investment outlook – what next for the world’s second-largest economy?
China’s lucrative property sector is under close scrutiny, with one of its biggest developers currently feeling the pressure. The People’s Bank of China has stepped up – but beyond the country’s current challenges, China remains a nation in flux. After pursuing a path of aggressive economic growth for decades, China’s government now wants to develop a more egalitarian society, which could redefine the relationship between the state and the private sector, presenting opportunities as well as risks.
Our investment experts from AXA Investment Managers share their current thoughts on the economic and investment outlook for the world’s second-largest economy.
Aidan Yao, Senior Emerging Asia Economist
We are seeing major policy changes in China, which can be classified into four groups. The first is aimed at de-risking the macro system, and this relates to the recent crackdown on the housing market. Second, there are its anti-trust measures – here China has fallen behind the US and Europe but it is starting to roll out more regulation. Third, there is data and national security – at the end of 2020 there were certain listing rule changes in the US that were perceived by China to be something that could potentially be used to force companies to pass on sensitive information to US regulators. To tackle this perceived threat, China tightened its data security requirements on technology firms. Finally, there is social equality and demographics i.e. the inequality between rich and poor.
Overall, China is undergoing a profound shift in its long-term development strategy in the pursuit of ‘common prosperity’. China’s burgeoning growth over several decades has created great prosperity, but that prosperity has not been commonly distributed.
On his rise to power, China’s leader Xi Jinping immediately started a poverty alleviation campaign. The reduction of poverty is about lifting people up from the bottom of society and pushing them towards the middle – while ‘common prosperity’ is about redistributing the wealth that is at the top of the pyramid, so it trickles down.
To achieve this longer-term goal we think Beijing needs to carry out major policy changes in three key areas. First, redistribution of wealth through taxation and other incentives. There is no wealth or inheritance tax, very little capital gains tax and almost no property tax in China, and these loopholes need to be closed. The second covers social spending, as about 9% of China’s GDP goes on social spending, versus an OECD average of around 20%1 .
Third, fostering fair competition and equal opportunity. Common prosperity is not about equalisation of income and wealth, as that removes incentives for workers and entrepreneurs, but about equalisation of opportunities. Some industries could be vulnerable to such regulatory changes – ones that enjoy excess profits, which have experienced significant capital-infused expansion, or those producing goods and services of public significance, or are a matter of security concerns.
The challenge for Beijing is to manage this balancing act between income generation and income redistribution, as well as growth sustainability over the long run and macro stability in the near term. These risks need to be managed carefully to ensure a smooth journey to common prosperity.
James Veneau, Head of Asian Fixed Income
China’s fixed income market has two components – onshore and offshore. The onshore market is the world’s second-largest bond market, and second-largest credit market. China bonds comprise 48% of JP Morgan’s Asia Credit Index (JACI) – already fairly substantial in terms of a regional strategic size, but to give an idea of the market impact of the Evergrande situation, earlier this year that figure was more than 52%2 .
Property developers comprise 21% of China’s offshore bonds and 10% of JACI’s, but it is in high-yield debt where China property is dominant, at 31% of JACI’s high-yield index.
The worst monthly performance on that index this year has been driven by China property. JACI China is still mixed between investment grade, high yield and real estate -– the latter pair have both been strongly negative performers this year.
Diversified indices, which have been more balanced and have less than 30% China exposure as opposed to around 50% for the full index, have outperformed. The JACI diversified high yield index, for example, has outperformed the JACI high yield index by 457 basis points (bp) year-to-date, driven by the recent volatility in the property space.
The best performance has been from the onshore markets with heavy government bond components. High yield spreads appear cyclically, and even historically, cheap. There is an around 500bp spread differential between BB and B rated – which we would usually consider a buy indicator, but most of this is due to depressed property valuations.
Investment grade and other high-yield sectors in our view broadly offer some relative value to US investment grade and high yield, but in the context of Asian credit are still cyclically expensive, which makes investing in this environment more challenging. We advise continued caution, especially with the various policy and economic uncertainties.
The developments relating to Chinese property firm Evergrande are quite significant for the wider sector, though it is important to remember Evergrande has always been a polarising issuer in an Asian credit context because of its size and levels of leverage. The sudden onset of distress did take the market somewhat by surprise – and typically, in these situations the market starts looking at other companies in the same sector and that has had a dampening effect on sentiment.
Furthermore, it could have a knock-on effect in terms of how high yield credit is priced in the market. One of most important cases for buying high yield had been the spread premium and low defaults, and Evergrande will potentially distort that, unless the market continues to view it as an exception.
Christy Lee, Fixed Income Senior Portfolio Manager
What has caused the significant sell-off in the China property bond market? Sales by property developers in the first half of this year were very strong – up some 30% to 40% – and even when you take out base effect from coronavirus, sales were still solid compared to 20193 .
The sell-off was caused by the policy tightening by the government in an apparent effort to cool property prices. The Chinese government has further tightened the mortgage approval process and has limited the banking sector’s funding to the property sector.
We think the policy tightening will speed up the consolidation process within the industry, so the big players will likely get bigger as they still have access to funding, and the smaller or weaker ones will either be acquired or will not survive. As such, we expect more credit divergence within the sector.
In terms of portfolio positioning, we have significantly de-risked our property exposure since late last year; we continued to hold short-dated bonds with less than two-year maturities and we have exited weak and highly leveraged property credits. While valuation has turned more attractive, we are still highly cautious in the sector, and do not think this is the time to go down the credit curve or extend duration.
For the rest of the year, we do not expect more tightening measures from the government nor a broad-based policy loosening targeted at the property sector. However, with onshore and offshore bond markets still shut for most China property developers, we think sentiment will remain quite weak in the near term.
In the longer term, we see the China property sector as still supported by strong real demand, driven by urbanisation and income growth and we believe that the very tight policy environment will benefit the stronger players, so credit selection is really key. We see the better-quality issuers as those with sites in cities with strong population inflow as well as those with good liquidity profiles. We avoid issuers with a very high reliance on bond funding, as we think the bond market could remain shut for these developers for the coming two to three months.
From the Chinese government’s perspective, social stability is always key. With around 25% of the country’s GDP tied to property4 , I believe their objective is for a property price cool down, but not collapse, and think it is unlikely we will see a lot of issuers in that space going to default.
In the case of Evergrande, we see Beijing’s priority as protecting home buyers, making sure unfinished properties are delivered first and suppliers and contactors paid. I think any restructuring process would be orderly, but US dollar bond holders would likely be in a relatively disadvantaged position as offshore bond holders are structurally subordinated.
William Chuang, China Equities Portfolio Manager
Looking at the case of Evergrande, there is a question of whether this will have a spill over impact on other sectors. We believe that the systemic risk is low, and importantly, the banking sector is safe. China’s housing market is very different from that of the US, where the leverage ratios are usually higher – for example in China the typical down payment on a house is 30% to 40%. The banking sector has also set aside RMB5.4trn worth of provisions, providing a decent cushion against rising bad debt5 .
There is however a crisis of confidence with homebuyers unwilling to buy from Evergrande, which cuts off essential cash flow to see projects through to completion. Additionally, we see the size of short-term payables on its balance sheet as potentially a risk to the broader economy. For example, the construction material value chain, which is comprised of a lot of small and medium-sized enterprises, is a segment that has not yet fully recovered post-pandemic.
However, we believe this policy cycle will turn out not too differently from the previous ones and could result in more attractive opportunities in the equity space.
Near term, the market will probably need to adjust its China growth expectation lower for this year and going into 2022. However, the property sector is only one of many stories in China, and we still see many positive ones. Our key strategy is to look for structural growth stories that will benefit from technology advancement or demographic shifts, with technology driving digital connectivity, automation, clean technology, and demographic shifts including ageing populations and a rising middle class.
We see China taking a leadership role in quite a few of these areas. For example, within clean tech, we have a strong conviction, based on the government’s commitment to renewable energy and electric vehicles. Over the near term we could see some volatility in these stocks, but we expect the policy tailwind to largely remain in place.
Our bottom-up thematic focus is on companies with a healthy growth rate and strong balance sheet and cash flow. These traits are important in a deleveraging environment as the ability to self-fund growth becomes a competitive advantage. The biggest risk we see right now is the power rationing situation, which will result in production cuts and rising commodity prices, putting a further squeeze on the manufacturing sector. However, we see this issue as transitory – and over the longer-term a potential buying opportunity where risk-reward appears attractive.
Chris Iggo, CIO, Core Investments
Looking at the broader market, we are confident the global economic recovery will continue into 2022 but we are very cognisant of the current supply side issues that will disrupt some of the economic data in the short term. These issues will potentially impact on investor sentiment – we have seen a pickup in volatility in fixed income and equity markets in September. We think these supply issues will ultimately be resolved, but it is likely the currently elevated inflation rates will persist beyond the end of this year.
In monetary policy terms, some central banks are preparing for an end to quantitative easing, and we expect the US Federal Reserve to make an announcement on tapering at its November policy meeting.
The European Central Bank (ECB), on the other hand, is likely to persist with its own asset purchase programme. The details around how it will deal with the end of the Pandemic Emergency Purchase Programme (PEPP) remain to be seen – we believe it could be extended, or to compensate for the end of the PEPP, the asset purchase programme could be expanded to allow the ECB to continue to provide liquidity for European markets.
The Bank of England has signalled that it may be the first of the major central banks to raise interest rates following its September policy meeting. There are some expectations that the first move could come before the end of this year, but we believe it is not likely until 2022 and the first increases we will see globally will be extremely limited. The low interest rate environment will remain supportive for the corporate sector, while corporate fundamentals remain extremely positive – notwithstanding some of the supply disruptions. Earnings so far this year have been strong, and in the US and Europe we are confident credit spreads should remain stable into 2022.
This backdrop supports our view on global equities generally – we are still overweight equities in our multi-asset strategies as fundamentals remain supportive. Valuations are a little more attractive in equities than in fixed income markets, and earnings run well above historic average, so in the medium term our view remains constructive on equity markets.