China and Hong Kong equity markets tested by a perfect storm

Update on China and Hong Kong markets

On March 14, China and Hong Kong markets (Shanghai Composite -2.6%, Hang Seng China Enterprise Index HSCEI -7.2%, and Hang Seng Index lower -5.0%) pulled back on several key developments:

• A widening COVID-19 outbreak in China—23 out of 31 mainland provinces reported confirmed symptomatic cases over the past week. If we include asymptomatic cases, there would be nearly 10,000 new cases overall.¹
• Several cities in China imposed restrictions on movements or lockdowns—This is to contain the outbreak, including Changchun in the northeast of the country, which is the tech hub of Shenzhen (where many tech giants are based) and the nearby industrial center of Dongguan (where many industrials or manufacturers are located).
• Regulatory pressures from abroad—On March 10, the U.S. securities regulator identified five Chinese companies as being noncompliant with the country’s Holding Foreign Companies Accountable Act. The American depositary receipt (ADR) prices of these companies declined in the U.S. trading on concerns about possible delisting.²
• Further geopolitical uncertainties relating to the Russia-Ukraine conflict—Russia reportedly asked China for assistance for military equipment, which is a claim China subsequently has denied.³

The near-term outlook: Hong Kong’s market valuation at a 10-year low

Russia-Ukraine tensions, coupled with China’s COVID-19 restrictions and regulatory risks from abroad, triggered a panic sell-off by investors, driving market valuations to historic lows. The price-to-book multiple (P/B ratio) on Hong Kong’s Hang Seng Index is now trading almost 0.9 times its book value, which marks a near-term bottom in the past 10 years (historical average 1.26x P/B), and is trading one standard deviation below this historical average.⁴

Despite a near-term dampening of investor sentiment, we believe the broad market has overlooked the long-term fundamentals of the Chinese equity market for the following reasons:

• Aggressive COVID-19 restrictions could slow economic activity or dampen consumption temporarily in major cities like Shanghai or Shenzhen; however, this week’s lockdown in China is expected to last one to two weeks and should contain the virus from spreading to other cities.
• The delisting risk of Chinese ADRs isn’t new. U.S. regulators have given affected firms with ADR-listings three years (may be shortened to two years) to meet several of the regulators’ requirements before delisting. A lot of negative news seems to have been priced into most of these Chinese ADR-related names (down 30% to 40% since last week’s announcement).⁵ We’ve long been aware of the regulatory risks associated with Chinese ADRs and expect China and Hong Kong capital market participants such as stock exchanges and investment banks to be beneficiaries as more companies return to the China A-share market or the Hong Kong market for listings.

Longer-term outlook: takeaways from the March plenary meeting

Another event last week that also captured market attention was the conclusion of China’s annual National People’s Congress (NPC). The government outlined multi-year plans to develop the nation’s technology and science sectors and reiterated its commitment to reducing energy intensity and ensuring that property prices remain stable.

At the meeting, there were encouraging signs that China’s determined to sustain economic growth and social stability. It’s fair to say that China’s fiscal policy is generally expansionary, with intensive spending coupled with tax refunds and cuts.

In summary, the key messages from the NPC plenary meeting underpin our belief that the Chinese government’s policies are significantly different from those of developed markets. We believe that economic stability remains a top priority for policymakers and that monetary tools remain in place for China’s central bank to support growth. 

Structural themes and sector opportunities 

In the near term, we expect market volatility to continue until there’s more clarity on the Russia-Ukraine situation, after the dust settles around COVID-19-related lockdowns and regulatory risks from abroad. Nonetheless, the recent sharp sell-off has created some deep valuation discounts that we believe do not reflect long-term fundamentals. Here are some structural themes and sector opportunities amid the current environment:

• In general, we remain selective and continue to favor sectors that should benefit from China’s 14^th Five-Year Plan (FYP). Preferred themes that could benefit from the FYP include consumption upgrades, research and development and innovation, renewable energy, energy transition, and new infrastructure.
• In our view, companies with dual-primary listings and that are eligible for China-Hong Kong southbound trading are in a more favorable position (i.e., improved trading and liquidity). The further expansion of southbound-trading eligible stocks remains a medium-term catalyst.
• Energy and materials are favored sectors from a medium to long-term perspective as near-term performance is mostly driven by spot-price movements; however, oil supply and demand may remain tight (in addition to geopolitical factors) and companies that have sufficient pricing power may benefit.
• Domestic-oriented companies (those with revenues derived in Hong Kong) such as Hong Kong banks and insurance companies will be key beneficiaries of U.S. interest-rate hikes. 
• We believe electric vehicle companies may be able to pass on higher input costs. These businesses could be potential beneficiaries as China's government outlined long-term plans to support renewable energy at the recent NPC.
• We may see further monetary easing in China as we enter the third and fourth quarter of 2022. The technology sector is sensitive to consumption spending, and we’re paying attention to the reacceleration of growth. We maintain a positive view on China’s semiconductor sector due to the nation’s self-sufficiency and strong domestic demand. 

China moves countercyclical to slower global growth

With Asian equity markets in a broadly risk-off mode, we expect continued volatility until there’s more clarity on the Russia-Ukraine situation.

While a broad market correction affects risk assets, we believe the overall impact on Chinese equities will likely be contained should the sharp risk-off episode subside. The fundamental implications for China are less prominent relative to Europe and the Western world.

In our view, China’s economy will continue to power ahead despite global macro uncertainty, moving almost countercyclically to other emerging economies and a slower global economy. The China A-share market is typically less correlated to global geopolitical incidents and may provide a diversification opportunity to international investors.

In the near term, global inflationary concerns may heighten given elevated energy prices. For China, inflation is expected to be manageable in the near term as the government can control energy prices through a cap on the coal price. Therefore, we believe China’s central bank has the monetary tools to support growth.

From a tactical perspective, as China decouples from the United States, we believe Chinese equities can be viewed as an alternative to global investors who would like to diversify from the U.S. Federal Reserve’s policy moves. 

Appendix: key takeaways from NPC meeting

China held its annual NPC from March 5 to March 11, an event closely monitored by investors for information regarding the country’s key economic targets and fiscal plans. Below are some of the key takeaways from the meeting.

• Primary economic targets for 2022

While China’s GDP growth target of around 5.5% (down from 6.0% in 2021) is the lowest in more than three decades, it’s still above consensus forecast of about 5.0%, and is higher than the International Monetary Fund’s projection of 4.8%. In regard to inflation, the Consumer Price Index (CPI) target has been set at about 3% (the same as 2021).

• Fiscal policy

It’s fair to say that China’s fiscal policy is generally expansionary, with intensive spending coupled with tax refunds and cuts. Fiscal spending will increase by 8.4% in 2022, with a more than 7.0% rise in China’s defense budget. The administration also announced a CNY2.5 trillion tax cut, about half of which is new and led by value-added tax (VAT) refunds for excess VAT input credits.

The NPC’s key economic targets

• Consumption

The administration outlined policies to support the use of new-energy vehicles and facilitate local governments to roll out green smart home appliances to rural areas, and encourage the trading-in of old appliances.

• Property

China plans to set up a financial stability fund and adopt measures to keep house prices stable as policymakers ramp up efforts to prevent systemic risks.⁶

Chinese leaders called on the property sector to help address rising demand from homebuyers. It was the first time nonsubsidized housing was mentioned in the event’s key report since 2014.

• Renewables

China’s Ministry of Finance said it would work to address funding shortfalls in subsidies for renewable power after years of rising debt resulting from inadequate payments, which we believe could be positive for wind or solar farm operators.⁷

At the meeting, the government also indicated that China would remain committed to its five-year goal of reducing energy intensity by 13.5% between 2021 and 2025. The country will continue to develop massive wind- and solar-power bases in desert regions and improve electricity grids.

• Innovation

To support the long-term development of the nation's science and technology sector, the government presented a ten-year plan to enhance basic research in those areas and a three-year plan to reform the scientific and technological systems. There may also be policies to promote the development of venture capital as well as new financial products and services.

1 Bloomberg, March 14, 2022. 2 Bloomberg, March 10, 2022. 3 Reuters, March 15, 2022. 4 Bloomberg, March 15, 2022. 5 Bloomberg, March 15, 2022. 6 Bloomberg, March 5, 2022. 7 Bloomberg, March 7, 2022.