End of zero-Covid policy, better Sino-US relations signal a good year ahead for Chinese stocks

For the first time in a long while, most of the critical factors needed to turn around Chinese stocks’ fortunes are aligned and changing for the better
Some longer-term challenges remain but there have been improvements in macroeconomic conditions, government policy and US-China relations

Laura Wang

Published: 1:30am, 23 Jan, 2023

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In less than three months, Chinese equities have surprised most investors. Both the Hang Seng and MSCI China indices have risen sharply while the rest of the global market has been largely flat. The S&P 500, for example, is up by about 5 per cent in the same period.

However, for many investors, it is not yet time to celebrate. Between February 2021 and November 2022, Chinese equities lagged global equity market performance and trailed their peers in both emerging and developed markets. The MSCI China Index declined by more than 60 per cent in absolute returns, underperforming the S&P 500 and the broad MSCI Emerging Market Index.

These 22 months also saw steady allocation reduction from Chinese equities into other regions. So, is now the time to get back into the China market? It seems so.

Morgan Stanley turned outright bullish on Chinese equities in early December after having been cautious for 23 months. For the first time in a long while, most of the critical factors are aligned and changing for the better.

Some of the longer-term challenges will remain, but after a tough year there has been a clear improvement in macroeconomic conditions. There are signs of a top-down pivot in government policy to stimulate the economy, some stabilisation in US-China relations and a steady improvement in clarity of the regulatory environment.

This unique recovery cycle, with structural improvements on the way, should set Chinese equities on a path to continue outperforming. This year could otherwise have been defined by slower demand growth and cuts in corporate earnings.

01:44

A first in 2 years: top economic officials from US and China meet face to face

First, look at macro and fundamental growth potential. The Chinese government recently announced 2022 GDP growth of 3 per cent, much lower than the 5.5 per cent target set by policymakers at the start of the year and the lowest annual growth in the past four decades, except for 2020.

Looking ahead, 5.7 per cent GDP growth can be expected this year, which is a strong rebound thanks to a swift pivot away from the zero-Covid policy. According to China’s National Health Commission, more than 900 million people have been infected, effectively achieving herd immunity nationally. This rapid post-Covid-19 reopening path has set up 2023 for an earlier and stronger growth recovery and, for most companies, a better revenue and earnings outlook.

Second, 2023 could represent a sharp contrast to 2022 when it comes to geopolitical uncertainty. Last year was defined by multiple unexpected twists and turns, which raised hurdles for those looking to invest in China – delisting risks for Chinese companies in the United States, Russia’s invasion of Ukraine, and so on.

After Chinese President Xi Jinping and US President Joe Biden met in Bali, both countries seem determined to maintain direct and effective communication in 2023. The US Security and Exchange Commission’s confirmation of China’s compliance on audit inspections significantly alleviated the near-term delisting risk.

03:33

Xi, Biden discuss Taiwan and Xinjiang in first in-person meeting

US Secretary of State Antony Blinken is expected to visit China in February. Meanwhile, China appointing its former US ambassador Qin Gang as its new foreign affairs minister is a clear signal of a more pragmatic and embracing approach to stabilising diplomatic relations.

Finally, the private sector, represented by large-cap companies, are coming back onto centre stage in terms of growth and opportunities after being entwined in a regulatory reset for nearly two years. Top policymakers have voiced support for the growth of these companies and emphasised their role in driving growth of employment, entrepreneurship, innovation and the general economy.

The operational environment for the private sector should become more stable as some high-profile regulatory cases are concluded and the companies affected prepare to move on. For example, Didi Chuxing’s ride-hailing service app resumed new user registration on January 16.

Didi’s relaunch of user sign-ups may not mark end to regulatory scrutiny

With these improvements, structural changes for the better are on the way. Chinese equities’ aggregate return on equity looks set to recover from the current 9.5 per cent to close to 12 per cent by the end of 2024, closing the gap against the broad emerging market by more than 60 per cent. Companies’ diligent focus on enhancing shareholder returns through cost-cutting, dividend payouts and share buy-backs will attract investors focusing on cash flow and the long-term investment horizon.

The price global investors are willing to pay for Chinese equities should rise as a result. Even after a market rally, the MSCI China index is still trading at a 7 per cent discount versus the broad emerging market.

China’s valuation will rise throughout the year and its discount against emerging markets will close as its equity risk premium continues to drop, along with improvements on the geopolitical, macro-growth and policy-priority fronts. Therefore, this will be a year for Chinese equities to shine.

They are off to a great start as we enter the Year of the Rabbit. The rabbit in Chinese culture is a symbol of youth, energy, peace and harmony. Will this year fully embody these traits? It has every chance of doing so.

Laura Wang is chief China equity strategist at Morgan Stanley

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