Active Thinking

Wendy Chen reflects on economic and market events during the first half of 2023, notably the impact of strained US-China relations. Wendy also explains how a hoped-for ‘revenge spending’ boost has not yet materialised - adding to China’s growth conundrum - and shares how she is aiming to capitalise on growth in China’s electric vehicle market.

20 July 2023

First of all, it is fair to say that the Chinese market caught a lot of people out over the first half of 2023. Things started well enough, following the narrative that the end of the zero-Covid policy and the long-awaited reopening would bring 15% of the world’s population back to centre stage, with a consequent boost to global supply chains and consumption. But sentiment turned abruptly in February in aftermath of the downing of the Chinese balloon over the US, with geopolitics playing a part as the market slumped - performing like said balloon - to the extent that the MSCI China index ended H1 -9% lower. The grilling of TikTok’s CEO at a US congressional hearing did little to assuage security concerns over the social media app’s state connections, with heightening US-China tensions weighing heavily on the market.

Geopolitics became the top overhang – the gap between China earnings and valuations widened since the deterioration of US-China relations, with the Biden administration following Trump’s trade and containment policy with the advanced chip export control and critical sector independence requirement. Notwithstanding soothing words from US Treasury Secretary Yellen’s visit to China in early July, since March the gap between earnings and valuations has widened, even as many Chinese companies beat estimates, underlining the extent to which strained US/China geopolitics dragged on the market in H1.

Overall, Chinese economic data has been decidedly mixed so far this year, with year-on-year GDP growth picking up from 4.5% in Q1 to 6.3% in Q2, albeit shy of forecasts of around 7.3%. While the economy has rebounded from the strict lockdowns that affected cities like Shanghai a year ago, with local government debt rising sharply, the Chinese authorities have been relatively cautious in their economic stimulus measures so far.

Key H1 issues: Domestic checks – tough to shift the growth engine

‘Revenge consumption’ disappointment

2023 looked set to mark the start of China’s shift to a consumption-driven economy. Optimism abounded over the effects of post-Covid re-opening ‘revenge consumption’ as the market expected consumers to unleash RMB 3 trillion of excess savings. But, as it turned out, people have been more cautious and tried to preserve cash, worried by the effects of the changing industrial landscape and the risk of unemployment, which has risen to record highs of 21% among 16–24-year-olds.

Property pain

Representing over a quarter of China’s GDP, the property sector continues to struggle. It is now three years into a downturn, leading to calls for meaningful support. Parallels between China’s property sector malaise and the real estate woes that dogged Japan for over a decade are not lost on investors, with the issue of China’s ageing population a further concern.

Thirst for stimulus

Multiple rounds of central bank stimulus have not really helped sentiment to any great extent, so investors are looking for a direct, measured stimulus package, ideally with a focus on the property market. For example, moves to close the interest rate gaps between outstanding and new mortgages, a relaxation of purchase restrictions in core regions and a broad-based cut in down payment ratios could be on the agenda.

Export outlook

Despite developed market demand softening amid geopolitical friction and strained western consumer budgets, outbound tourism increasing and supply chain resilience improving following the end of the zero Covid policy, our expectations are that China’s trade surplus can be sustained.

What does this mean for us?

We are starting to less favour internet-focused companies like Alibaba and Tencent and instead focus on those that we think can benefit from policy tailwinds, as well as selected companies in the durable goods sectors. For example, on a thematic level, we are aiming to capitalise on the growth of the electric vehicle (EV) sector. Even ignoring the export potential, the sheer scale of China’s domestic EV market, including those bought to replace traditional internal combustion-engined vehicles, has seen EV sales rise nearly sevenfold in just three years.

Unusually in the EV market, China’s local names call the shots over Tesla

BYD, one of our core holdings, has been outdoing Tesla in terms of monthly sales, in part helped by consumers’ perception that BYD is a more affordable option than the luxury/premium tranche of Tesla. But, importantly, both BYD and Li Auto, another of our major holdings, focus on extension range EVs (EREVs). In our view, the significantly longer range between charges adds to their relative appeal for many buyers, as the rollout of charging point infrastructure remains behind schedule and has so far concentrated in and around Tier 1 and Tier 2 cities. So, for the time being at least, we are concentrating on these EREVs, until such time as the government commits to putting more capex into building the charging infrastructure that could eventually benefit pure EV players like Tesla, NIO and Xpeng.

High-conviction EV theme players stand in contrast to formerly dominant internet names

Once synonymous with the Chinese market, high-profile internet-focused stocks like Alibaba, Baidu and Tencent are seemingly not attracting the same high-conviction, long-term investors these days, turning them into effective beta plays. In little over two years, the GS China Internet basket has been prone to up to eight separate short-term double-digit rallies, virtually all of which have seen gains largely fizzle out in a matter of weeks. While we retain our focus on conviction views in sectors such as EVs on a long-term-hold basis, short-term volatility in other sectors can present tactical opportunities.