Investor Insights -

Covid, cars, and commuting – China’s zero covid policy has far reaching consequences

It has been a tumultuous year for global financial markets, not least in China. Although Chinese assets make up a smaller portion of our portfolios, our Investment Committee spend a lot of time discussing, debating, and researching the country.

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It has been a tumultuous year for global financial markets, not least in China. While the volatility in the US and Europe can be attributed to high inflation, the US Federal Reserve rapidly raising interest rates and the war in Ukraine, China’s issues are more localised. The US remains the leader in setting global interest rate policies and possessing the pre-eminent reserve currency. But in many ways, China has more impact on the global economy. As such, although Chinese assets make up a smaller portion of our portfolios, our Investment Committee spend a lot of time discussing, debating, and researching the country.

The main issues confronting China this year are COVID-19 and the property sector. COVID is now receding into the rear-view mirror for most of the developed world with well-established vaccination programs. It is a different story in China, which continues to adhere to a rigid ‘zero-COVID’ policy aiming to crush all outbreaks via targeted lockdowns and mass testing. This has led to major cities across the country such as Shanghai to completely shut down, and at the time of writing this has led to huge falls in the mobility of people, as illustrated by the charts below.

‘China: April activity data plunged on escalated Covid restrictions – First take’ 

**Surveyed unemployment rates moved up in April, recording their highest levels since the data was released in January 2018

 

‘China: April activity data plunged on escalated Covid restrictions – First take’ 

This has hurt the economy. Consumption, measured by retail sales, fell 11.1% compared to a year earlier, following another 3.5% decline in March[1]. Spending in restaurants was down nearly 23% versus the prior year[2], and, according to the Financial Times, not a single car was sold in Shanghai in April. Weak consumer sentiment combined with high unemployment has weighed on the prices of Chinese internet stocks, many which have profits heavily linked to consumer spending and advertising. Behemoths such as JD.com, Alibaba, Tencent and Meituan have already been buffeted by waves of regulation from the Chinese Communist Party (CCP), and with millions of people unable to spend across the country, the sentiment towards internet stocks remains weak.

KWEB is an exchange traded fund (ETF) that invests in Chinese technology and internet companies.

The property sector, for so long a huge driver of economic growth in China, and to a lesser extent, the global economy, has also suffered. China’s property sector is heavily indebted and has been kept afloat by ongoing support from government-backed banks for years, owing to its systemic importance.  Traditionally, homebuyers buy properties before completion. Cash developers then use the money to develop more. It is a dangerous business model as it relies on strong ongoing demand and easy availability of debt.

The government finally acted in 2021, introducing ‘three red lines’ related to debt that developers must meet. It sent shockwaves through the Chinese and Asian property and bond markets, as China’s largest property developers – notably Evergrande—are the biggest issuers of debt in Asia.

Evergrande, China’s second largest property developer by sales[3] has been the biggest casualty of this crackdown. Evergrande equity collapsed with around $300 billion in debt, representing the largest debt restructuring in China’s history. Sunac, another enormous developer, has also defaulted on its debt obligations[4]– one of many casualties of the cash and liquidity crunch across the sector.

Meanwhile, demand has been hit by lockdowns. Residential home sales by value fell nearly 47% in April[5] and house prices have turned negative, a major issue in an economy so historically reliant on the sector to generate demand.

 

“Courtesy J.P. Morgan Chase & Co., Copyright 2022., WIND”

 

While the immediate outlook in China is bearish, we await promised stimulus from the government to support consumer confidence which has yet to materialise in any meaningful way. The government’s immediate priority appears to be suppressing COVID, a policy that is key for President Xi’s bid for an unprecedented third term as President later this year. Until that goal is achieved, it is difficult to see a path out of the current difficulties facing the country’s economy.

 

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Author -

Freddie Gabbertas

Freddie Gabbertas

Investment Management, Head of Emerging Market and Asian research

Freddie joined Arbuthnot Latham in 2016, and is head of Emerging Market and Asian research. He sits on the Global and European equity and Fixed Income pods, whilst also looking at Ethical and ESG mandates. He holds the IAD and IMC qualifications and graduated from University College London with a B.A. (Hons) in Geography. 

Find out more about the Investment Management Team