The anticipated rebound following China’s reopening did not materialise as expected when the country lifted most pandemic restrictions earlier this year. Some optimists had even wagered on China leading the global recovery or playing a role in curbing global inflation through its cost-effective production capacity.
After the initial few months of euphoria — which, in hindsight, was premature — Chinese and Hong Kong markets began to mirror the more realistic and sobering reality. “The year following China’s reopening from Covid-19 unfolded as a story of dashed hopes,” says DBS.
“Consumers returned to restaurants and cinemas but largely refrained from big-ticket purchases. Consumer confidence data highlighted this negativity,” says Ronald Temple, chief market strategist at investment advisory firm Lazard.
The new era of geopolitics, sparked partly by the US-China trade war, has played a role. China’s lower-than-expected recovery can also be attributed to domestic factors. “The root cause of the economic lethargy are problems in the real estate industry, which have affected property developers and municipal finances and have ultimately contaminated the broader economy,” adds Temple.
China has been on a real estate binge for decades. Numerous tycoons made their fortunes by taking on piles of debt to build ever bigger and more luxurious properties for their countrymen who are facing societal pressure to jump on the property bandwagon.
Depending on how the numbers are calculated, real estate makes up between 15 and 30% of China’s GDP. Real estate accounts for between 60 and 70% of a typical household’s assets. “This means housing prices majorly impact psychology,” adds Temple.
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Speculative real estate
While there was a genuine need in the earlier years, recent demand has been driven by speculators betting on continued price increases. President Xi Jinping has repeatedly warned that houses are meant for living, not speculation. “Ultimately, the central government cracked down on developers by enacting a ‘three red lines’ policy that limited leverage in the sector and shut off financing,” says Temple.
With growing defaults, concerns about the real estate sector expanded. Temple says publicly available data does not fully depict the negative news. The widely cited 70-City House Price Index in China only covers new home prices in Tier 1, 2, and 3 cities.
When developers gain approval to market new projects, the launch prices are set in agreement with local authorities. While they cannot lower those headline prices subsequently — which would impact the index, developers can offer bonus amenities such as a free parking spot or credits to buy appliances — which has the net effect of lowering prices.
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The 2% to 5% dips in the 70-City House Price Index do not reflect the discounting occurring, cautions Temple. Anecdotally, resale prices are down 15% to 20% in Tier 1 cities and even more so further inland, implying a significant hit to consumer net worth and a much more dire story than public data imply.
“Fortunately, this does not mean China faces a US-style housing bust or a financial crisis, as regulations on loan-to-value ratios are much stricter in China than US rules in 2005–2008,” says Temple.
“Even with home prices down 15% to 30%, homeowners in China still have sizeable equity cushions and remain in the black. However, this loss of net worth still does not bode well for consumption and confidence,” he adds.
To an extent, the same sentiment is felt by foreign investors. In October, the net outflow of funds reached the highest level in seven years. “Foreign investors may become less pessimistic about China if policymakers could successfully prevent a hard landing by effectively mitigating the risks associated with the property market,” says DBS.
The way Lazard’s Temple puts it, the Chinese government was watching “passively” as its economy faltered, only to stir in the second half of the year with a slew of measures to prop up the economy and increase demand for housing, including investment properties (see table).
“While I do not expect a flood of credit stimulus due to China’s elevated debt levels relative to other large economies, I do believe we will see continued steps to ensure a minimum level of growth into 2024,” adds Temple.
China 3.0
Of course, China’s policymakers are aware of the challenges. In their own way, they have been actively nudging the economy to adapt to a new era, which commentators such as UBS call “China 3.0”.
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Under the first version in the early 2000s, China was the world’s factory, where cheap mass production was the key. This was followed by China 2.0, marked by debt, infrastructure, and a digital boom in the aftermath of the global financial crisis, notes UBS.
“China 3.0 is getting underway as the economy attempts to transition from old-world growth drivers — property and lower-value manufacturing — to a new-world trinity of mass consumption, the green transition, and tech innovation,” adds UBS.
Still, the Swiss bank warns that rebalancing will not be easy due to debt and property that are so tightly interwoven. Investors need to ditch the old expectations of seeing China grow at 10% a year and make do with its GDP growing at just 4% to 4.5% over the next five to 10 years. “Policy support, however, can help smooth the fluctuations — ongoing easing, for instance, may boost growth to around 5% in 2024 in an upside scenario,” says UBS.
Economic outlook
In any case, Lazard’s Temple believes that sentiment regarding China has gone too negative. Reasons for his view include the array of recent stimulative measures and the sharpness of the decline in new housing construction, which has already occurred and will likely lead to stabilisation in building activity in 2024. “Moreover, there are signs of consumer confidence and spending bottoming, suggesting near-term improvement is at hand,” he adds.
The view is shared by UOB Kay Hian’s Tham Mun Hon, who projects the Chinese economy to gradually climb higher in 2024, hitting 4% y-o-y growth, with private consumption providing much of the heavy lifting.
“Smart consumption and premiumisation plays should outperform as consumers generally continue to focus on cost-effectiveness. The higher income group will retain their purchasing power, similar to during the pandemic period, allowing companies that can pursue a premiumisation strategy to enjoy better margins,” says Thum.
UOB Kay Hian’s preferred picks within the consumer discretionary sector include sports apparel maker Anta, apparel contract manufacturer Shenzhou International, casino Galaxy Entertainment, and e-commerce giant US-listed PDD Holdings.
The brokerage likes two other stocks under the consumer staples sector. The first is Hang Seng Index constituent stock China Resources Beer, which brews brands such as Snow in a joint venture with SABMiller. This brand is the world’s best-selling beer by volume. The second pick is Kweichow Moutai, the company behind the baijiu (white liquor). Despite criticisms of conspicuous consumption, it remains the preferred choice for toasting, especially when things are looking up.
