J.P. Morgan Private Bank’s Alex Wolf: How investors should think about China exposure

In a new research piece today, Alex Wolf, Head of Investment Strategy, Asia, J.P. Morgan Private Bank, comments how investors should think about China exposure, given the latest growth and policy developments, and outlines his current investment recommendations:

“With China continuing to be one of the biggest topics of conversation with clients globally, here are our answers to the most frequently asked questions –

Does China’s “first-in, first-out” COVID status mean growth has peaked?

Broadly yes, but growth is still robust. Various economic indicators suggest that China’s “first in, first out” advantage already largely faded as other economies, particularly manufacturing powerhouses, were also able to resume production.

Highlighting this trend, April data was mixed – external demand remained strong driven by the continuing global rebound, however domestic demand remained soft. Household consumption has continued its gradual recovery following lingering local virus outbreaks and an elevated sense of uncertainty among consumers, which has also motivated precautionary saving.

Exports have remained a strong point though: China exports continued to grow at a healthy clip given the large positive spillover effect from generous fiscal support in developed economies. In fact, the recent resurgence of the mutated COVID strain in Vietnam and India meant that in some sectors, orders are again outpacing supply (such as in medical equipment). Overall export growth may be past its peak, but we think it will stay resilient rather than decelerate sharply.

There are also questions around the consumer recovery. As of March, China’s retail sales growth has recovered to around 6% y-o-y growth (adjusted for base effects), compared with a pre-pandemic growth rate of 8-10%. There are a few reasons for this slower pace of consumption.

First, there has been a relatively small amount of stimulus offered directly to households, especially compared to many advanced economies.  Second, the impact of local virus outbreaks on services lingers on. Provinces such as Hubei and Liaoning that have experienced virus outbreaks and local lockdowns have also displayed a significantly slower services recovery.

China has been removing COVID-related stimulus. How much more tightening can we expect and what are the global spillovers?

We think most of the tightening is behind us, as policymakers began dialing back policy stimulus in mid-2020. The budget deficit for 2021 was scaled back, implying less investment growth from the public sector. The People’s Bank of China (PBoC) has also been tightening the credit rein. Various measures of broad credit growth are either back to pre-pandemic levels or just slightly above it, and are more or less in line with forecasted nominal GDP growth – which is the PBoC’s target.

We think further policy moves from here will be data-dependent. If economic data matches expectations, we will likely see another 1-2ppt of credit growth tightening in the next six months, which is very mild by recent standards. While it could still keep a lid on financial market confidence, it will be manageable for corporates and consumers.

From here we see the risks to further tightening as relatively balanced. If the growth recovery slows unexpectedly, policy might ease. Conversely, if the global fiscal push keeps China’s industrial sector close to full capacity for longer and global price pressures continue to rise, we might see interest rates move higher and policymakers talk more hawkishly about certain parts of the asset markets.

Does China’s slow pace of vaccination hinder its (or Asia’s) recovery?

Possibly yes, and this is having a knock-on effect across regional tourism-dependent economies.

According to China’s Center for Disease Control and Prevention, as of May 20, China has administered a total of 467 million doses of vaccine (out of a population of 1.4 billion people, and given the current two-dose regime, this translates into a maximum vaccination rate of 16.7%). While the pace has picked up markedly in recent days, this still puts China meaningfully behind the vaccination leaders such as the U.S., the U.K., Israel, and even the EU.

For China, the slow pace of vaccination reflects a mix of challenges, including the supply and logistical challenges of vaccinating 1.4bn people in a short period of time. As production ramps up, and other more effective vaccines are being developed, China should be on track for more meaningful vaccine coverage by the end of 2022 or early 2023.

Domestically, occasional flare-ups (like the ones witnessed in early 2021) have brought additional economic costs due to tightened restrictions. It also means that health officials and the general population continue to be on high alert, leading to a sluggish consumer recovery, particularly in services.

The travel sector is one case in point. During the recent long weekend holiday, domestic tourism improved, but only to 80% of 2019 levels. International travel remains heavily restricted and comes with onerous testing and quarantine policies. While this situation may improve gradually alongside more vaccinations, the tourism sector (which accounts for 3% of Asia’s GDP and 4% of employment) will likely be amongst the last to see normalization.

In this sense, China’s sluggish vaccination progress could have a significant knock-on effect for the rest of Asia. For many tourism-dependent economies such as Thailand, China makes up approximately 30% of inbound tourists. As long as Chinese travelers face quarantine on their return home, they are unlikely to travel abroad, hindering a full recovery in economies that depend on the flow of Chinese tourists.

What are our current views on Chinese assets within the context of a global portfolio?

From an investment perspective, we need to balance the various forces in place. On the one hand, the growth recovery has been pretty steady and policy tightening has not meaningfully surprised in either direction. On the other hand, regulatory tightening remains a headwind for a large part of the market (particularly MSCI China, which has many of China’s tech giants).

Geopolitical tensions are also persisting. These headwinds could persist in the near-term.

So in equities, we are cautious on the tech and internet sectors while favoring more cyclically-oriented sectors and exposures such as A-shares. In the fixed income space, we continue to reduce duration and diversify our exposures. We are still wary of the impact of targeted tightening on the property sector, but continue to like China Government Bonds (CGBs). In the currency space, we still think the RMB should be on the stronger side vs. the USD this year.

Given the balance of risks, how should investors think about China exposure in a portfolio context?

We think a multi-asset approach, spread across not just asset classes but different types of exposures (for example off-shore and on-shore listed equities) works best from a risk-return perspective. A multi-asset portfolio consisting of five assets – 10-year government bonds, investment-grade corporate bonds, high-yield corporate bonds, offshore equities (MSCI China), and onshore equities (CSI 300) – recorded an annualized return of 7.5% in USD and a Sharpe Ratio of 0.75x since mid-2009.

This type of approach is helpful given the different types of exposures even within asset classes. For example, offshore and onshore equity indexes offer a different sector composition and different exposure to China’s GDP growth. In recent years the CSI 300 better reflected nominal GDP, albeit with volatility (see charts).

The five-asset portfolio has delivered even higher average annualized returns than that of onshore equities (7.5% vs. 6.4%) with lower volatility (10.5% vs. 25.6%). As an additional benefit, the maximum drawdown from this strategy was -15% versus -38% for MSCI China and -43% for the CSI 300.

This framework can help mitigate many of the idiosyncratic risks across China’s markets, such as high volatility in equities and the difficulty in assessing credit risks. Most importantly, a multi-asset approach has historically provided a better risk-adjusted return than equities alone.”

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