03 Mar 2021
Louis Luo, Investment Director, Multi-Asset Solutions
Investing in the right active strategy will be key as momentum for China’s V-shaped rebound moderates once the rest of the world recovers and Beijing normalises policy.
Now the world’s second largest economy, China continues to grow at a far faster rate than other major markets. Driven by investment, manufacturing and exports, GDP expanded 2.3% year-on-year in 2020. It underlines how China’s economy was first in, first out of the Covid-19 pandemic and the successful measures taken to contain the initial outbreak and subsequent infection waves.
However, there are reasons to think this rate of recovery will moderate. As the rollout of vaccines gathers pace in the US and Europe, we anticipate a slowdown in China’s exports by the year’s end as production activities pick up in rest of the world and consumption rotates from goods to services . We also expect a normalisation in fiscal policy.
This indicates that 2021 could be a year of two halves: a strong first six months, followed by a slowdown in growth momentum as policymakers prioritise sustainable growth and the external environment becomes more contested.
Investors will need to think carefully about where to commit their capital in 2021, what to avoid and where the risks are. Here we offer a macro-economic and asset allocation overview, touching on both equities and bonds and highlighting historical patterns and what investors might anticipate this year. Security selection will be critical if and when the broad market beta rally moderates in 2021.
A V-shape: Initially driven by a recovery in industrial production, recently consumption and investment have gathered steam. Consumption will be the key indicator to monitor in order to gauge the health of China’s economy in 2021 as the government looks set to withdraw much of its stimulus.
Industrial Production, Retail Sales and FA
Source: National sources, Bloomberg as at 31st December 2020
No decoupling: China’s trade growth surprised to the upside in 2020. A rotation of consumption towards goods in developed markets drove Chinese exports. But as this reverses alongside Covid-19 inoculations, we expect trade to normalise towards the end of the year.
Trade Condition and Current Account
Source: National sources, Bloomberg as at 31st December 2020
Credit inflection: we saw a surge in Total Social Financing (TSF) – credit growth driven by fiscal stimulus. Now we are seeing a turning point amid policy normalisation. History suggests PMI – an indicator of economic activity – will also peak. Still, that does not mean China will suffer a major slowdown, only that financial conditions will move from accommodative to a more neutral stance. TSF growth will likely moderate gradually.
Credit Impulse vs PMI
Source: Bloomberg as at 3rd January 2021
Subtle shift: The kink in the market rate Negotiable Certificate of Deposit (NCD) AAA yield came as the government paused its tightening cycle and injected liquidity to safeguard recovery. Policymakers assured investors that they won’t tighten too quickly, pointing to stability in policy rates (LPR 1Y & MLF 1Y). If companies remain able to borrow at low rates, that bodes well for earnings.
Policy and Market Rate - II
Source: National sources, Bloomberg as at 17th January 2021
Valuation re-rating: strong A-share returns last year were driven by a valuation re-rating, not earnings growth, as investors front-loaded their 2021 recovery expectations. It was the same story offshore (MSCI China), although earnings proved a little more resilient because MSCI China has a heavier weighting in tech stocks.
Equity YoY Return Decomposition - Onshore Equity
Source: Bloomberg, Aberdeen Standard Investments as at 3rd February 2021
Equity YoY Price Return Decomposition - MSCI China
Source: Bloomberg, Aberdeen Standard Investments as at 3rd February 2021
Earnings catch-up: For a sustained rally, investors will need earnings growth to deliver in 2021. We can see the leading market indicator – combining new PMI orders, industrial inventories and industrial profit growth – has recovered sharply. History suggests earnings per share – lagging the leading indicator by six months currently – will catch up this year.
Composite Leading Indicator vs Equity Earnings YoY Growth
Source: National sources, Bloomberg, Aberdeen Standard Investments as at October 2020
No bubble yet: The A-share market surged over 30% last year, prompting bubble fears. But while domestic equity fund allocations are elevated, they’re below 2015 levels. Global inflows via Stock Connect are also elevated, as are A-share trading volumes, but again nothing to compare with 2015. While this points to room for further inflows, investors should remain wary of crowded sectors and look for opportunities that are underappreciated.
China Domestic Mutual Fund Positioning
Source: Bloomberg, Wind as at 3rd February 2021
SH+SZ North Bound 3M Flow as % of NB quota
Source: Bloomberg, Wind as at 3rd February 2021
SH+SZ total trading volume in CNY
Source: Bloomberg, Wind as at 3rd February 2021
Real divergence: China’s real interest rate has never been so attractive relative to the US and Europe, with the spread in real yields at its widest. The rise in yields suggests the bond market has already priced in some degree of policy normalisation in China, reflecting its underlying growth divergence with the developed world.
Real Interest Rate (10Y Yield - Core CPI )
Source: National sources, Bloomberg, Wind, Aberdeen Standard Investments as at 31st December 2020
Yields and returns: history shows the current bond yield is a good indicator of bond returns over the next 12 months. The 10-year Chinese government bond yield has bounced back from last year’s low point to around 3.2%, around its long-term average and attractive given negative sovereign bond yields in much of the developed world.
Bond Yield vs Future 12M Bond Return
Source: Bloomberg, Aberdeen Standard Investments as at 3rd February 2021
Flight to quality: the spread between local AAA-rated company credits and government bonds has tightened close to an all-time low of 85 basis points, while those for lower-rated credits widened. This divergence follows a wave of defaults last year amid uneven economic development across China. As policy tightens, lower-grade credits will likely remain under pressure in 2021.
Credit spread vs 5Y China Onshore Gov't Bond
Source: Wind, Aberdeen Standard Investments as at 29th January 2021
We think China can sustain its V-shaped recovery, with strong exports and production for the first half of 2021. But leading indicators such as credit growth and PMI appear to have reached inflection points, so the maximum speed of recovery is likely behind us.
Policymakers stepped up monetary and fiscal stimuli last year. Although they have indicated there will be no sharp turn of policy in 2021, we expect growth support to be more selective and targeted.
After a re-rating of valuations, equity investors will be looking for earnings to justify their interest. The A-share market has become a consensus long among domestic and global investors, albeit not in bubble territory yet. Our analysis suggests companies are poised to deliver earnings growth and that 2021 will be another positive year for Chinese equities.
At the same time, Chinese bonds have seldom looked as attractive relative to developed markets given the wide gap in real yields. Investors can expect a 2-4% return in local terms.
But one segment of China’s bond market not doing so well is lower-grade credit. As policy tightens, we expect this segment to remain under pressure. We urge investors looking for a yield pick-up over government bonds to stick to the highest-rated local credits.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.