The case for China
For equity investors, peak pessimism presents potential opportunities.
Just spent a month in China and everywhere I went, everyone was negative. Store owners. DiDi drivers. Executives. Entrepreneurs. “Fundamental doesn’t work in China now” has become a new consensus among institutional investors. Sentiment was extremely depressed, with many blaming draconian Covid lockdowns and the government’s 3-year crackdown on wide-ranging sectors such as internet, property, tutoring, to name a few. Some talked about leaving or investing/expanding outside the country, and about sending their children to the U.S. for college or even K-12. Underlying this gloom and doom is an economy that, after sprinting out of the gate on the lifting of zero-Covid policies at the start of the year, stumbled after the first turn. Y/y Q2 GDP missed forecasts, consumption disappointed, manufacturing activity contracted a fourth straight month in July and money has flown out of the equity market (where individuals last year accounted for roughly 60% of the CSI 300 Index volume) and into money funds. “If we’re all going to lose money, we might as well cut our losses,” a 57-year-old teacher told The Wall Street Journal.
So why do I think China’s bear market is over? Unlike consensus, I believe the government realizes it went too far. Its “anti-monopoly” push, “prevention of disorderly expansion of capital” advocacy and “Common Prosperity” reforms targeting private enterprise and so-called “platform” giants such as Alibaba, Tencent and DiDi stifled entrepreneurial spirits and the economy’s upward trajectory. The suppression began nearly three years ago when, at a Shanghai summit that included senior leaders, Alibaba founder Jack Ma harshly criticized Chinese regulators for not doing the job right and stifling innovation. A day later, Alibaba affiliate Ant Financial’s IPO was suspended and a the growth-inhibiting reforms followed. That’s why July 19 is so important. That’s when the Communist Party’s top leadership and the State Council (China’s cabinet) issued a 31-point action plan to improve the business environment for private enterprises, including adding “outstanding” private sector members to the government’s lawmaking and advisory bodies. On the surface, the communique was rather broad and vague. Many skeptics understandably dismissed it, including my esteemed fixed-income colleague. A lot of my contacts said it’s just talk. But if you step back, I think it’s clear that senior leaders want to reverse their regulatory crackdown, and quickly.
This view was reinforced four days later when, in a July 23 Politburo meeting communique laying out new policies to stabilize China’s economy, President Xi’s “Housing is for living, not speculation” mantra was absent after being used at every April and July Politburo meeting since 2019. Phrases such as “to invigorate capital markets and boost investor confidence” were added, the latter a first for Politburo meeting language. Days later, the Housing Ministry and People’s Bank of China started guiding banks to lower mortgage rates and downpayments, moving to end onerous restrictions that required home buyers to put down as much as 80%! Elsewhere, China’s SEC is now asking how to boost investor confidence. A cut in the stamp duty tax is being discussed. And China’s national planning agency is looking at ways to boost consumption. All important signals and actions. If markets ignore them, I think we will see more and more. Downside risk management suggests the more the market doesn’t trust, the more policymakers must act boldly. Consider the global financial crisis. The Fed kept cutting rates until zero. Still, markets didn’t believe. So, it went further with quantitative easing. Finally, the markets believed.
As an investor, I want to be early because when the tide turns in China, it tends to turn fast. That’s what I think is going to take place. Government leaders are going to keep introducing stronger and stronger medicine until it works. It helps that negative sentiment is at an extreme, valuations are historically low (a recent JPMorgan note said the MSCI China has de-rated more in 28 months than Japan’s TOPIX did in 13 years after its bubble burst) and earnings growth is improving, particularly among internet companies. By my playbook, improving earnings, low expectations, very low valuations and very light positioning are all bullish. Sure, there are risks. Earnings could disappoint. Maybe all the talk about new policies will prove to be just that—talk. Geopolitical risks aren’t going away. Demographics are a long-term drag. And the biggest risk: you never know what’s going the happen—the last time I was feeling good about China’s market, a wayward balloon stole global headlines. But to me, it feels like we’ve made a bear-market bottom. Is it a new bull? Remains to be seen. At worst, maybe the market goes sideways. And there always are potential opportunities in sideways markets.