China’s policy tailwinds set economic recovery in motion
With the first half of 2022’s market events behind us, we see a brighter outlook for Chinese equities in the next six months.
The government recently reduced quarantine times for inbound travelers and announced an easing of lockdown measures—encouraging signs that more relaxation of restrictions is yet to come. Chinese equity markets are rebounding from valuation troughs amid an improving market sentiment, the lifting of lockdowns, and a slew of stimulus measures. With China’s pro-growth policies expected to continue, we expect opportunities to arise in three investment themes in the next six months: policy tailwinds, innovation, and a consumption upgrade among consumers. We remain constructive on the asset class and expect policy executions to accelerate in the second half of the year. We also believe that longer-term investors will be rewarded for participating in these sectorial opportunities.
Market overview: Chinese equity valuations are rebounding from multi-year lows
As lockdowns began to ease toward the end of the second quarter, Chinese equity valuations have rebounded from multi-year lows. During the first quarter of 2022, which coincided with the peak of new COVID-19 cases, global financial markets, including China’s stock markets, declined. Back then, it was a perfect storm of risk-off events: Russia-Ukraine geopolitical tensions, regulatory curbs on technology stocks, the potential delisting of Chinese firm’s American depositary receipts, and a hawkish U.S. Federal Reserve (Fed).
In the past two months, China’s stock markets have staged the first phase of their rebound on the back of a raft of COVID-19-related relaxation measures. Investor sentiment has recovered as lockdown restrictions are gradually eased; the Hong Kong government accelerated to reopen its borders in May by cutting the required quarantine period for inbound travelers (from 14 days to 7 days) and eased social distancing measures. In June, China shortened quarantine times for those entering major cities: Visitors will only need to spend 7 days in a quarantine facility followed by 3 days of home quarantine. This is down from 14 days of hotel quarantine in many parts of China, and as many as 21 days previously, according to a revised government protocol.1
China and Hong Kong stock markets rebound from policy support
(April 29–July 1, 2022)
Source: Bloomberg, as of July 1, 2022. Index performance is based on total return in U.S. dollar. It is not possible to invest directly in an index.
MSCI China Index performance and valuation (10-year)
Source: Bloomberg as of July 1, 2022. It is not possible to invest directly in an index. LHS refers to left-hand side; RHS refers to right-hand side. PE refers to price/earnings ratio.
At the time of writing, the MSCI China Index and the Hong Kong and Chinese onshore A-shares indexes have rebounded since May, and their respective price-to-earnings (PE) valuations have recovered from multi-year lows. We believe Chinese equities could have more room to run due to attractive valuations—they’re sitting below the historical average and near the bottom of the standard deviation range. We’re also more constructive of the second half outlook, which we highlight in the next section.
Mid-year outlook: economic reopening and policy support
China’s first-quarter GDP beat expectations and grew 4.8% year over year. We expect China to experience a reacceleration in GDP growth in the remainder of the year, while most Asian central banks (excluding China) are likely to raise rates (partly) as a result of U.S. dollar strength. Recent economic data—including China’s industrial output, exports, and retail sales—have been picking up and the Purchasing Managers’ Index for June returned to the expansionary territory of above a 50 reading. These are signs that factory productions are resuming and pent-up domestic demand is being released.2
A raft of economic stimulus measures was announced throughout the first half of 2022, which should permeate the real economy. Numerous sectors are expected to benefit from a further macro policy push in the second half, providing a stronger boost to consumption and helping to ease supply chain bottlenecks. Investors might also increasingly view China as a diversifier of risks and returns. While global central banks are dealing with elevated inflation and expected rate hikes, the People’s Bank of China’s been pursuing a divergent monetary policy. The central bank lowered the country’s reserve requirement rate by 25 basis points (bps),3 slashed the 5-year loan prime rate by 15bps, and further reduced the mortgage-rate floor for first-time homebuyers.
We believe China still has room to ease monetary policy further amid below-target inflation, a development that should support the labor market. In addition, the property market has stabilized, although further clarification is needed in two areas: When China would move on from its zero-COVID policy and when the political landscape will settle following the 20th Party Congress.
In terms of fiscal policy, there’s a decent probability that China’s National People’s Congress Standing Committee may approve additional fiscal stimulus at its August meeting, likely in the order of CNY1 trillion. On June 23, President Xi Jinping reiterated China’s commitment toward preestablished 2022 growth targets.
All in all, we believe that the fiscal and monetary stimulus announced in May 2022 has set the stage for further economic recovery in the second half of the year, and markets have yet to fully price in the more constructive outlook.
Sector opportunities: cyclical and structural tailwinds in three investment themes
We identify three key investment themes for the midyear that continue to benefit from continued policy support.
1 Policy tailwinds
Powering growth with renewable energy and the auto sector
At a time when elevated oil prices push up global inflation, China’s been making progress in its efforts to tap into clean and alternative energy. On the renewable energy front, China aims for carbon emissions to peak by 2030 and plans to achieve carbon neutrality by 2060. According to the National Development and Reform Commission, China plans to raise the share of non-fossil fuels in its primary energy mix to 25% by 2030 (from 15.9% in 2020) and expects the total installed capacity of wind power and solar power to reach more than 1.2 billion kilowatts.4 As such, we continue to see solid investment opportunities in the renewable energy sector; for example, in terms of installed capacity, China produces 87% of the world’s polysilicon, a vital component of the solar supply chain.5
China’s primary energy consumption by source
Source: BP statistics, Our World in Data, IEA, Daiwa, as of September 2021. Renewable includes hydro, solar, wind, nuclear, and biofuel. 2030 estimate based on National Development and Reform Commission target, as of January 2022.
Global polysilicon capacity breakdown
Source BNEF, BofA Global Research, as of April 2022.
Another beneficiary is the auto sector, a key contributor to China’s consumption growth. In May, authorities relaxed car purchase restrictions and halved the car purchase tax for small engine passenger cars priced under CNY300,000 with engines no larger than 2.0 liters. For context, roughly 90% of engine-powered vehicles in the market will likely be eligible for the incentive.6 Encouragingly, the tax cut was larger than expected and should benefit traditional auto manufacturers. Retail sales of passenger vehicles have already edged higher since the introduction of the new tax policy, topping 1.96 million units in June. We expect Chinese automakers to continue to accelerate their production and deliveries from June 2022 in anticipation of a demand recovery.
China retail passenger vehicle sales
Source: Bloomberg, as of July 13, 2022.
In regard to infrastructure spending, the State Council announced plans to use funds from the local government special bond (LGSB) program to support a broader range of projects, including new infrastructure initiatives such as next-generation technology and 5G.7 We believe infrastructure construction may accelerate in the third quarter of 2022 if the LGSB quota is used up by June and could be used to fund projects by August 2022.
Devloping a digital economy and high-value global manufacturing hub
We continue to see opportunities that leverage the government’s goal of developing a digital economy and strengthening China’s position as a high-value global manufacturing hub. Ongoing industrial automation and manufacturing upgrades led by advanced technology could also lead to new opportunities. In our view, recently announced incentives support innovative growth:
- In March, China announced a 10-year plan to research and reform the nation’s scientific and technological systems. This can benefit industries related to biomedicines, high-end instruments, green and low carbon energy transformation, and basic software.
- We also expect new energy vehicle manufacturers to benefit from the government’s “New energy vehicle (NEV) to rural” campaign, which uses exhibitions and promotional activities to boost sales of new energy vehicles, especially in rural areas.8 In addition, local governments are offering subsidies (or coupons) to assist with vehicle purchases.
In light of the growing adoption of renewable energy, we expect demand for battery storage or energy storage systems (ESS) to rise; indeed, China’s installation of ESS is expected to grow at a 56% (cumulative average growth rate) over the next decade.9
In the longer term, we believe China will play a pivotal role in the global electric vehicle (EV) supply chain, with Chinese EV battery manufacturers leading the way. The lithium ion battery is the most important component of an EV and Chinese companies produce over half of the world’s EV batteries.10 Outside of China, ASEAN economies are also developing their own EV supply chain, which creates opportunities for China’s companies that have exposure to different parts of the EV supply chain.
China’s role in the global EV battery supply chain (2021)
Source: Morgan Stanley, as of January 3, 2022. EV refers to electric vehicles.
There’s also a growing list of other companies in the EV supply chain, including makers of components such as battery precision parts, car charging stations, electric motors, automotive lens and sensors, and other EV-associated products. We think the long-term outlook for these EV component providers is also promising.
We believe Chinese makers of advanced driver-assistance systems (ADAS), for example, are poised to benefit from a structural shift toward energy efficiency and changing consumption patterns of the younger generation. ADAS are applications and technologies that are installed into self-driving (autonomous) vehicles that serve multiple purposes from injury protection, pedestrian detection, night vision, road safety, and cruise control to automatic parking. Components of an ADAS can range from hardware or software, chips, sensors, and radars to cameras and lenses.
We predict ADAS suppliers will see the penetration rate for their products grow as the demand for autonomous vehicles increases. According to the projections of China Association of Automobile Manufacturers, the country’s ADAS market recorded sales of CNY84.4 billion in 2020; industry reports expect the market to reach CNY225 billion by 2025.
ADAS sales in (CNY billion)
Source: China Association of Automobile Manufacturers, EqualOcean, as of May 8, 2022. ADAS refers to advanced driver-assistance systems). E refers to estimates.
Lifestyle and product upgrades amid changing demographics
With stimulus measures under way, we expect consumption growth to pick up in the second half of the year. China’s travel, tourism, and hotel stocks have rebounded after the government announced a relaxation in travel rules and lifted lockdowns.11 Domestic consumption-related stocks (e.g., restaurant operators and local retail businesses) are also benefiting from the government’s decision to reduce quarantine times for those who’ve been in close contact with COVID-19 patients.
The free digital yuan handout campaign launched in Shenzhen and Hebei may further stimu