China’s L-shaped recovery

The following is an extract from our Q2 Asset Allocation outlook.

As top investment banks are split on China’s growth prospects, we sit in the pessimistic camp. Why?

For starters, China is still in the thralls of a property market correction. Estimates of the housing overhang range from two to three years of sales.[1] Although the government has announced some social housing projects, details are scant, and estimates suggest additional demand amounts to a mere half year of sales.[2]

In addition, housing sales – already down 45% from 2019 levels – continue to contract.[3] With half of developers facing severe financial stress, households are not confident that pre-paid houses will ever be delivered. The government has, so far, failed to solve this crisis of confidence.

Second, the property downturn has put many local governments in a difficult financial position as they rely on land sales for revenues. As major conduits of fiscal stimulus they may be missed in action when they are most needed.

Indeed, late last year the central government instructed 12 of the 34 local governments to curtail spending and halt some infrastructure projects.[4]

The central government is picking up some of the slack by issuing an ultra-long bond equivalent to 0.8% of GDP, but most estimates see the augmented deficit rise by just 0.5% of GDP.[5] This is 1.5 percentage points more stimulus than last year, but not enough to meet the growth target, in our view.

Finally, China does not have the benefit of rebounding from zero-COVID this year. Some 80% of growth was due to consumption last year. With pent-up demand out of the way, this is unlikely to be repeated. On the contrary, a weak labour market and depressed prices of property – households’ main asset – are likely to weigh on consumption.

The statistical carry-over is also weaker. If GDP remained at the end-2023 level this year, average GDP would be 1.6% higher than last year. Last year, the statistical carry-over was 1.9%.

The risks to our economic outlook are two-sided. On the downside, financial stress in the property sector or among local governments could lead to a credit crunch. On the upside, policymakers could increase stimulus and finally address the crisis of confidence in the property sector.

What this means for our positioning

The difficult backdrop for growth contrasts with a growing sense of optimism from investors. To be clear, the Chinese stock market has had a dire few years and sentiment is far from exuberant. But we think the flurry of small announcements from policymakers that led Chinese equities to rally over 15% between 22 January and 21 March are being extrapolated too far. It is also worth remembering that Chinese companies’ earnings per share have a very loose relationship with macroeconomic growth.

So, we are tactically underweight Chinese equities and prefer other equity markets. But this is a short-term view, and we will look to add Chinese equities back if we see any sign of sustained growth in earnings per share.

The above is an extract from our Q2 Asset Allocation outlook.

[1] Sources: IMF, 2023, China, Selected Issues. www.imf.org/en/Publications/CR/Issues/2024/02/08/Peoples-Republic-of-China-SelectedIssues-544651 and LGIM calculations.

[2] Source: Dragonomics, 13 November 2023, The quiet stimulus to construction, and LGIM calculations.

[3] Source: Macrobond as at 20 March 2024.

[4] Source: Goldman Sachs, 6 Mar 2024, Beijing’s Balancing Act between Infrastructure Stimulus and LGFV Deleveraging

[5] Source: Goldman Sachs, 6 Mar 2024, Beijing’s Balancing Act between Infrastructure Stimulus and LGFV Deleveraging; JP Morgan, 5 March 2024, 2024 NPC takeaways.