In our analysis, investor sentiment and valuation in Chinese equities are currently at unsustainable lows. As such, we are positive on the relative case for the Chinese equity market’s prospects as we move into the latter part of this year. While we can expect the realisation of some degree of slowing growth, policy tools are available to underpin the economy so it should not be fully de-railed.
We have identified several positive catalysts that could help China’s market recover. These include an easing of zero-Covid restrictions, a reduction in geopolitical tensions and clear evidence of no further tightening in the regulatory environment. We see reasons for optimism in each area. The government is likely to continually adjust Covid-19 policies — driving greater economic resilience and flexibility in the face of localised restrictions—and utilise flexible policy tools. We anticipate stabilisation in earnings revisions, and a regulatory shift towards implementing previously announced policies versus incremental new tightening measures.
Monetary policy in China has followed a different trajectory from the US and other major central banks, as interest rates in China have been trending lower, with 10-year yields in the US now higher than in China for the first time in over a decade.
Opportunities from government long-term goals
We believe areas aligned with the government’s long-term goals offer the most opportunities for investors. Common prosperity, for instance, could expand the aggregate size of disposable income and support social welfare, as lower-tier cities remain a large untapped market for many consumer products and services. Green development, with orderly decarbonisation to avoid disruption to economic growth, should enable Chinese companies to secure global leadership in supply chains spanning from new energy vehicles (NEVs) to solar.
In our view, sectors with high exposure to NEVs, solar, wind power and energy storage have upside potential due to strong NEV growth momentum, high energy prices, the ongoing Russia-Ukraine war and government subsidies. In addition, gaining independence from imports through domestic substitution in key technologies, such as semiconductors, represents a huge growth opportunity with strategic benefits. Putting this in context, China imported over US$400 billion ($557.9 billion) in semiconductors in 2021.
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Other opportunities can be found in high-quality Internet companies that have seen valuations crash, yet they have vast amounts of cash on their balance sheets, are improving their cost efficiencies and are returning cash to shareholders.
Sectors and companies where we see risks
In our opinion, risks exist in industries characterised by oversupply and excess leverage (such as property developers) and restricted earnings growth and returns to shareholders (such as utilities managed for public benefit, not for minority investors). We see companies with weak cash flows that are reliant on fundraising to support business operations as vulnerable due to a lower risk appetite. We also expect sectors with high consumer exposure to be under pressure in the next few quarters due to low consumer confidence and weak demand.
See also: Time to rethink traditional thinking in emerging markets
We will continue to search for opportunities in the Chinese equity market, as we actively manage our portfolios based on bottom-up company research and top-down macroeconomic and policy monitoring. We retain long-term optimism towards China’s market.
Michael Lai is portfolio manager, China equities, at Franklin Templeton Emerging Markets Equity
