China equities buck global sell-off with bumpy recovery intact

Volatility is up. Here’s what to do next (5:30)
We’ve seen outsized moves across asset classes. Here's what we think.

The outperformance of Chinese equities has stood out in recent weeks as global markets have slid on fears that rapid central bank rate hikes to curb inflation may hurt economic growth. The gains in the MSCI China index have been particularly noticeable given that, up until a few weeks ago, Chinese stocks had been under considerable pressure due to renewed COVID-19 outbreaks, which led to protracted lockdowns and strict measures in major cities.

But since mid-May, Chinese equities have embarked on a bumpy recovery following signs that the economy troughed in April. The MSCI China has gained 2.2% so far this month while the MSCI All Country World index declined 10.2% and the MSCI International All Country Asia Pacific index lost 6.9%. We retain a most preferred rating on Chinese equities within our Asia strategy given recent positive developments.

Macro data from last week has shown recovery momentum gathering pace. China’s industrial production in May rose 0.7% year-over-year (y/y), following a 2.9% y/y contraction in April as more automobile manufacturing resumed. While retail sales remained below last year’s level, the contraction narrowed to –6.7% y/y in May, from –11.1% y/y in April, partly due to a recovery in auto sales. Fixed-asset investment growth in May jumped to 4.7% y/y, from 2.4% y/y in April.

While China’s economic recovery remains uneven, with production and investment resuming more quickly than consumption, the activity data affirmed it is gathering pace.

Reopening progress remains intact, despite near-term setbacks. Beijing last week delayed the reopening of most schools, as COVID-19 cases spiked once again. Shops and restaurants near the center of the latest outbreak were closed, while many bars, movie theaters, and gyms were shuttered. However, over the weekend the city declared that the outbreak was under control. High frequency data, including subway ridership and traffic congestion indexes, has shown improvement.

Separately, although residents in several Shanghai districts were locked down for two days of mass testing two weeks ago, the operation did not expand into wider curbs. Logistics-related indexes have also rebounded. In our base case scenario for China, rolling mini-lockdowns will be the new normal for the rest of the year. As long as these do not reach the scale we saw in April and May, we expect them to be less economically disruptive. China’s recovery in the second half remains on track, in our view.

Recent regulatory tightening on tech may be coming to an end. Technology stocks have led the recent outperformance of Chinese equities as Beijing’s policy messaging has become more supportive this year. State-run media have reported that authorities are expected to roll out measures to support the technological innovation of internet platform companies following the politburo’s call for a “healthy development” of the sector. We retain a positive medium- to long-term view on leading Chinese tech names and believe that a stable regulatory backdrop would prompt the sector to rerate.

So, we expect China’s economic recovery to pick up in June as policy support kicks in and economic activity improves further with the reopening momentum. We anticipate 2022 earnings growth of 9.8% for the MSCI China.

In addition to cyclical and value sectors, we see opportunities in reopening beneficiaries with quality income growth, including select names in the new economy, consumption, auto, tech, industrial, and renewable energy sectors. In particular, we prefer companies that can rerate significantly due to a sequential recovery in revenue and stronger earnings, despite inflationary cost pressures.