Economics will prevail over fearmongering and politics, writes Dr Xiaolin Chen, head of international, KraneShares.
In 2001, China entered the World Trade Organization (WTO) and became the world's factory, orchestrating what would become the economic miracle of the century. A decade later, China opened its doors to foreign investment, and investors piled in, hoping to capitalise on the next economic miracle: the consumer. While today's markets look exceedingly different than in 2001, and investors are questioning the underlying thesis for investing in China following a challenging period, the long-term story remains intact. China still warrants a place in a global portfolio due to its size, growth prospects, and differentiated risk and return characteristics.
Putting the 2022 uncertainty behind
Nonetheless, 2022 saw the convergence of three obstacles to both growth and economic opening: the zero Covid policy, the deterioration of US-China relations and the real estate taper tantrum. China entered 2022 with a clear mandate from its government to lift growth. Its aggressive stimulus campaign began to bear fruit during the first quarter of 2022, as economic data such as purchasing managers' indexes (PMIs) and fixed asset investments (FAIs) in real estate, manufacturing and infrastructure began to stabilise and turn upward.
However, a severe lockdown in Shanghai in April and subsequent lockdowns in other major cities halted progress. Meanwhile, the fallout from regulatory changes affecting the real estate development industry lingered longer than expected despite a commitment from the government to stabilise the sector. If it had not been for the severe Covid-related lockdowns or an important political year, China's economic data and potential currency performance might have told a different story in 2022, a story it may yet tell in 2023.
The conclusion of the NPC and the re-election of President Xi, along with a new Standing Committee and Politburo, should give the Chinese government more latitude to make the hard decisions required for progress. There are already encouraging signs that China is back to business: it reopened its economy following the strict lockdown regime of 2022, supported the real estate industry's recovery, and worked with US regulators to resolve the audit dispute that had put its top internet companies at risk of delisting from US exchanges.
The end of US assets' outperformance
The rapid rise of the US dollar in 2022, driven by the most aggressive US Fed rate hikes on record, wreaked havoc in most international currencies, including the Renminbi. This could represent the last leg of US assets' outperformance over the past 15 years, and the benefits of US investors' home bias, developed over the past two years, could be eroded in 2023 as the dollar peaks and the US enters a recession, making country diversification more important.
While offshore stocks, predominantly representing internet companies, suffered from industry regulations and geopolitical risks, the A-Shares market, predominantly consumer staples, healthcare and clean technology benefited from the stimulus and supportive policies. Allocating to both onshore and offshore China could provide exposure to the potential return to growth in 2023 in a risk-managed way.
The year of the rabbit... and the consumer
China may leap back to growth in the year of the rabbit after a challenging 2022, but its growth largely hinges on one variable: the consumer. As external demand falls due to an impending recession in the West, China's economy must rely more heavily on the consumer. Furthermore, emerging industries such as cloud services and semiconductors, though promising, may take years to contribute significantly to China's economy. Fortunately, reopening and a fresh infusion of capital in China's real estate development industry have the potential to boost consumer confidence significantly, which would be a catalyst for China markets in 2023. Xi Jinping's unprecedented third term has given investors trepidation when it comes to allocating to China.
However, for now, it appears that pragmatists are winning out against ideologues in Xi's administration. Even Xi himself has demonstrated a return to pragmatism in the easing of his cornerstone zero COVID policy. Therefore, his next cornerstone policy may be focused on the economy. In 2023, investors should take a holistic view of China's capital markets, incorporating into any allocation both onshore and offshore stocks and bonds to both manage risks and ensure exposure to the greatest possible opportunity set.
While zero Covid and real estate are being addressed now, other concerns will take longer to be ironed out. An improvement in US-China relations will require enhanced pragmatism from both sides. However, one can be optimistic that, ultimately, economics will prevail over fearmongering and politics.