by Andrew Rymer, CFA – Emerging Markets Investment Specialist
After such a strong recovery from Covid-19 last year, 2021 was always going to be a different story for China. After all, China led the macroeconomic recovery from the initial outbreak of the pandemic; the so-called “first-in-first-out” effect.
However, regulatory reforms, the energy crisis and real estate volatility as a result of regulatory actions and concerns over Evergrande, have proven additional issues for markets to negotiate. And this led to some contrasting performance between bond and equity markets in 2021.
From a Covid perspective, China has now double vaccinated over 75% of its population. At the same time, it has maintained a strict border control, with quarantine requirements still in place. With uncertainty created by the Omicron variant, these look set to remain in place into next year.
There are multiple considerations to weigh up for 2022. Will the zero-tolerance Covid approach be lifted; can slowing economic growth begin to ease; and are regulatory pressures set to lessen?
David Rees, Senior EM Economist
The sharp slowdown in China’s economy that began in the second half of 2021 will spill over into 2022, ensuring that GDP growth will remain slow. We have pencilled in GDP growth of 4.7%, down from a projected 7.7% in 2021.
While the government’s zero-tolerance Covid-19 policy remains in place, restrictions to contain outbreaks of the virus will continue to periodically hit activity, particularly in the services sector. The arrival of the Omicron variant is a concern in this regard. Government intervention has greased the wheels of the energy sector after blackouts hit activity. Even so, coal reserves are likely to remain stretched through winter at the very least. As a result, manufacturers face higher energy costs at a time when demand for exports looks set to soften.
However, it is the real estate sector that is of most concern. A crisis of confidence regarding the health of highly indebted developers has caused sales of new property to dry up, taking away a key source of financing and leading to a downward spiral of weaker construction activity, more debt restructurings and weaker sales. Policymakers have shown a greater pain threshold for problems in the real estate sector, consistent with the government’s broader regulatory reforms aimed at achieving “common prosperity”. But the authorities are likely to step in at some point to steady the ship, given the potential negative consequences for the financial system and economy at large from a complete meltdown in the housing market. Even so, the lags between weak sales of land and new properties and activity mean that construction will be weak in 2022 and this sector has historically been equivalent to about one fifth of GDP.
The good news is that none of this will be complete surprise to markets. Incoming data may still surprise on the downside in the near term, but our long held concerns about a slowdown in China have now become the consensus view and markets will be focusing on any signs of improvement. An announcement of fiscal stimulus, perhaps geared towards investment in the energy transition, could give a shot in the arm to confidence.
We will also be looking for an upturn in leading economic indicators for signs of future improvement. For example, while the credit impulse – the 12 month change in new lending as a share of GDP – continued to decline in October 2021, signalling soft economic conditions into the summer of 2022, it did so at a slower pace. The impulse may trough and pickup around the turn of the year implying an improvement in activity in the second half of 2022.
Investors should also get more clarity on how government reforms will be implemented. Any easing of measures aimed at industries such as technology and education could support assets in those sectors. And any boosts to household disposable income from reforms and potential stimulus measures could help consumption, which has so far lagged behind in the recovery.
Louisa Lo, China Fund Manager
China is unlikely to reopen its borders in 2022, given its zero-tolerance stance. As a result, the recovery in consumption is likely to be domestic-led, which should pick up as Covid eases on the back of strict measures and higher vaccination rates.
Producer price, or factory gate, inflation may peak in 2022 thanks to industrial normalisation globally. Overall supply chain improvement is also expected in 2022, as we do not expect any severe lockdowns in any major economies. More importantly, select consumer companies with strong brand power may be able to pass through high input costs to end consumers amid a better consumption environment. So 2022 could be a better year for high quality consumer stocks.
While producer price inflation may peak soon, it is unlikely to retreat to a significantly lower level. China is heading into a period of structural inflation, driven by longer term factors such as an ageing population, the focus on decarbonisation, and the continued and prolonged quantitative easing around the world.
We expect new infrastructure and green-related capital investment to be the key areas of growth, in line with the country’s policy direction. Traditional infrastructure investment may increase modestly on the back of more supportive fiscal policy next year, but we do not expect a massive jump as local governments will also need to follow the country’s broader debt reduction efforts. On the other hand, the slowdown in property investment is likely to continue given the ongoing property market deleveraging.
Although supply-side bottlenecks may be resolved next year, exports may slow in 2022 as the tailwind of overseas lockdowns fades. This reinforces the importance of dual circulation; the emphasis on longer term exports growth while also promoting domestic consumption, localising research and development, and boosting import substitution. As such, domestic consumption is likely to be a key growth driver from 2022 onwards.
The policy direction is clear, with debt reduction and narrowing income disparity the top priorities. The policies can be fine tuned if necessary but will not be reversed, in our view, as a long term shift in economic drivers and de-risking are still the focus of policymakers.
Although there has not been a significant improvement in US-China relations since President Biden was elected, there has equally been no major deterioration either. Encouragingly, the countries also have expressed openness to resuming dialogue. A silver lining amid the tensions is that the US may lower the tariffs previously imposed on China, in a bid to lower domestic US inflationary pressures. Nonetheless, we believe the US/China relationship will remain relatively bumpy, and even potential trade tariff reduction progress does not necessarily guarantee a meaningful market re-rating. China will continue to promote dual circulation in the face of heightened geopolitical tensions.
The correction in Chinese equities in 2021, which has seen valuations for many popular stocks pull back sharply from elevated levels, is throwing up more interesting opportunities in a variety of sectors. We believe overall market valuations are healthy, despite some significant differences across sectors, and provide more downside protection amid the still challenging macroeconomic environment expected in 2022.
Julia Ho, Head of Asian Macro
Although we may not see a repeat of the strong relative outperformance of 2021, we remain very bullish on Chinese onshore bonds going into 2022.
The case for investing in China’s bonds remains very strong. Economic growth has decelerated from high single-digit growth rates over the past decade to a projected 5% in 2022, as China shifts its economic focus from the quantity of growth to the quality of growth. While this may provide a more sustainable and stable economy in the future, the slower overall growth rate is positive for bonds, as interest rates are likely to remain low.
The decline in the credit impulse has also led monetary policy to remain accommodative. While global central banks are ending quantitative easing programmes or beginning to hike interest rates, China stands out as the only large central bank to have eased monetary policy recently. This stance means there is likely limited downside in Chinese bonds, providing a favourable medium-term risk-reward profile.
Secondly, the new themes of common prosperity, regulatory reform, and deleveraging are all supportive of bond investments. As China has become richer overall as a nation, it is now focused on social and wealth equality. Regulators are addressing excesses in various areas such as the housing market, as well as working on long term reform in areas such as education, health care, and online gaming. China’s “first-in-first-out” economic recovery from the pandemic has provided it with a window of opportunity to implement these reforms without incurring too much disruption to its growth trajectory.
The National Party Congress in October 2022 also serves as an impetus to implement reforms. We expect there to be some short-term pain required to achieve long-term gains, as the stress in the property market has shown. All of these developments are “bond bullish” as investors may remain cautious and add to China bonds as a defensive asset amid lower growth expectations and potential bouts of volatilities.
Over a longer-term horizon, Chinese demographics are peaking and the overall population, ageing; again this could be positive for bonds. As a result of the historical one-child policy, China’s total and working age populations have likely peaked. Meanwhile, the population is also ageing rapidly, with increasing demand for fixed income products. The newly announced three-child policy is unlikely to arrest the demographic trend as young people in China, like other Asian and European countries as they became richer, are hesitant to have children. This trend of ageing and declining population is negative for growth and positive for bonds.
Finally, Chinese bonds as an asset class have come of age, as investors are starting to view them as an emerging safe-haven asset. The outperformance during the pandemic in March 2020 and amid the global bond rout in the first quarter of 2021 demonstrated the resilience of China bonds. Attractive valuations, a supportive economic backdrop, divergent monetary policy, growing accessibility, ongoing index inclusion, low volatility, and diversification benefits are just some of the reasons we continue to favour China bonds.
Additionally, as China continues to promote its currency as an international reserve currency, China government bonds will play a critical role as an anchor investment asset in renminbi.