By William H. Witherell, Ph.D.
After a steep decline in 2021, Chinese equities have provided a rollercoaster ride for international investors so far in 2022, as positive surges meet headwinds that halt the market rally.
For example, the SPDR S&P China ETFs, FXI, after bottoming in mid-March, has recorded several partial recoveries and has been trending lower since early July. In this note, we discuss some of the cross currents affecting the Chinese stock market and the Chinese economy.
Several recent developments are bullish for Chinese equities. Most significant for U.S. investors is the Aug. 26 announcement that U.S. and Chinese regulators have reached a preliminary audit agreement that will allow the U.S. Public Company Accounting Oversight Board (PCAOB) to inspect records. reports produced by audit firms in Mainland China and Hong Kong. Kong.
It is hoped that this agreement will resolve a dispute between the United States and China which threatened the possibility of delisting in 2024 some 200 Chinese companies currently listed on American stock exchanges. The combined market value of the endangered stocks is approximately $1.4 trillion.
It appears that the Chinese audit records of Alibaba (BABA), which is audited by PwC, and Yum China (YUMC), which is audited by KPMG, will be the first to be inspected. The Big Four accounting firms are auditing some 130 Chinese companies listed in the United States, which should help implement the deal.
A handful of Chinese companies will initially be audited by the PCAOB, perhaps as many as 20; and by the end of the year, these audits will determine whether China and Hong Kong meet US standards. The greatly reduced risk of delisting in the United States should provide a tailwind for companies listed in the United States.
Delisting risk had been a significant overhang in the market for these companies. The agreement is also a welcome signal that the two governments can still come together to produce a positive outcome.
Recent actions by the People’s Bank of China (PBOC) were also a positive development. September 5ethe reserve requirement rate on foreign currency deposits, ie the amount of foreign currency deposits that banks must hold in reserves, was reduced from 8% to 6% by the PBOC.
This decision will increase liquidity in foreign currencies and reduce the pressure to depreciate the currency. This reduction in the ratio was the second this year. The ratio was reduced from 9% to 8% in April. The central bank has made it clear that it is concerned about the rapid depreciation of the currency, over 3% since mid-August.
The strength of the US dollar and the divergence between US and Chinese monetary policies are the main drivers. The PBOC is well aware of the upcoming 20e Party Congress in October. Its bias against CNY depreciation has been evident in its recent daily currency fixings.
More broadly, the PBOC is pursuing a policy of targeted monetary easing, which appears to be creating a rebound in credit activity. This is good news, as a liquidity crisis in the real estate sector threatens the recovery of the economy.
This sector represents 20 to 30% of GDP and 70% of household wealth. Weak August inflation data should allow this approach to continue as most other central banks struggle with high inflation.
Another positive development of longer-term significance to China’s financial system is the establishment of a new Financial Stability Fund, or FSF, which will be a key addition to China’s financial system safety net.
The FSF will be the lender of last resort when all other support measures fail and will therefore complement China’s existing rescue mechanisms. Credit risks, especially for small banks with insufficient capital, are increasing; and real estate sector defaults have increased significantly.
The headwinds facing Chinese equities are many. The economy slowed markedly during the summer. The S&P Caixin China General Manufacturing Purchasing Managers’ Index (PMI) fell in August, indicating deteriorating operating conditions, with production growing at the slowest pace in three months.
The services sector PMI continued to show a strong increase in service sector activity in August as the disruption caused by the pandemic and related restrictions eased. A negative warning, however, came from the reported sharp drop in export sales for the services sector, reflecting weakening external demand.
That warning was repeated in the August trade figures for China, as China’s trade surplus was weaker, with shipments of goods to the rest of the world rising just 7.1% from a year ago, a sharp slowdown from July’s 18% growth.
The slowdown was driven not only by weaker external demand as global economic output contracted in August, but also by the severe drought and heatwave in central China and another round of lockdowns. of Covid.
The highly contagious Omicron variant of Covid is a major challenge to China’s economic growth. While most of the rest of the world is living with endemic Covid, China’s zero Covid lockdown policy, which currently involves tens of millions of people in megacities like Chengdu, is failing.
Insufficient vaccination of the elderly is one factor, but more important is China’s inability to produce an effective vaccine or antiviral like Pfizer’s Paxlovid and its reluctance to purchase non-Chinese vaccines.
Authorities have tried to refine the approach to lockdowns to reduce negative economic effects. But until there are meaningful changes in policy, further Covid outbreaks will present headwinds for the Chinese economy and Chinese equities.
There are also downside risks due to the geopolitical situation. US-China relations have become more strained when it comes to Taiwan and the South China Sea. Moreover, on the technology front, new US restrictions that could block sales of high-end processors from US chipmakers have been condemned by China as technological “hegemony”. Previous prospects for the reduction or elimination of Trump-era tariffs on Chinese exports to the United States now seem unlikely at this time.
Forecasts for the Chinese economy have been revised downwards. A slowdown in global economic growth seems likely: less than 3% this year, before moderating to nearly 2% next year. This slowdown would limit any further growth in Chinese exports.
Additionally, we expect a delayed recovery in consumption due to the risk of further Covid outbreaks and weak job and income prospects. Public sector spending on infrastructure and business investment in strategic sectors will be the main drivers of growth over the next 12 months.
These considerations lead to forecasts for growth in China of around 3% for the current year, with the stalled recovery accelerating in the remaining four months, and around 5% per annum in each of the next three years.
Such growth in the world’s second-largest economy would still be a major support for the global economy as the United States, Europe and Japan seek to recover from much lower growth rates.
Despite a few failed recoveries, the Shanghai stock market is still down more than 10% since the start of the year, and the Shenzhen market is down more than 20%. US-listed Chinese ETFs are down more, in part due to the more than 8% depreciation of the Chinese currency and the conversion of Chinese prices into US dollars.
There is certainly room for Chinese ETFs to outperform in the coming months with, for example, the previously mentioned FXI down almost 40% from its April 2021 peak. In the medium term, the China’s economy is expected to grow at a pace surpassed by few if any other economies.
Still, there are significant downside risks. At Cumberland Advisors, we are significantly underweight China in our international and global equity ETF portfolios, but that could change overnight as we monitor developments.
Neither Cumberland Advisors nor the author owns the only security mentioned in this note.
Sources: Financial Times, Oxford Economics, The Wall Street Journal, CNBC, etf.com, S&P Global, China Last Night, Goldman Sachs Economics Research, Brown Brothers Harriman.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.