Slowdown in China

Telemus Weekly Market Review September 11th - September 15th, 2023

A point of optimism that sparked markets to start 2023 was the expected rebound in the Chinese economy following the removal of COVID-19 related restrictions. The removal of the restrictions led to a boom in economic activity during January, but conditions quickly retreated. As the year has advanced, China’s economy continues to regress. A primary contributor is the weak property (real estate) market in China. Property prices have been falling as developers have taken on too much debt and there are now an estimated 40-50 million vacant units  throughout the country.  The property market has an outsized influence on the economy given that it accounts for roughly a quarter of the China’s Gross Domestic Product (GDP)ⁱ. Moreover, by one estimate 70% of household net worth comes from the value of their primary residenceⁱⁱ.  

Given the strong ties between the property market and consumers, confidence levels have plummeted. This has resulted in reduced consumption, which ultimately fueled deflationary conditions in July when the country’s consumer price index (CPI) hit a negative -0.3%. This past week, CPI data showed a modest reversal, as inflation inched to the positive up +0.1% during the month of August. A Telemus colleague recently visited China and confirmed firsthand the unusual softness in consumer activity. He noted that few people were dining out and falling prices in the property sector seemed to be impacting the desire of many individuals to spend. 

An added issue has been a sharp drop in exports. Exports had fallen -14.5% over the past year. Geopolitical tensions and increasing desires to onshore/nearshore production due to supply chain disruptions have negatively impacted China’s industrial activity. In previous cycles the strength of the economy’s export engine has enabled them to weather softer conditions domestically. 

Should we see a more prolonged slowdown in China’s economy, it’s likely to be felt beyond the country’s borders. Key trading partners such as Germany and Australia are likely to be impacted. In fact, Germany’s industrial activity has been contracting for several months. Commodity prices might also feel some pressure from less demand as property market construction slows. This has recently influenced a slowdown in export activity out of Australian. In addition, a key beneficiary of the past strength in China’s economy has been the luxury goods market. A weaker Chinese consumer could negatively impact demand for these items.   

A growing concern that some investors and economists are having is whether China will be facing a ‘Japanification’ of their economy. The concern being a sustained period of deflationary pressures that keep consumers from spending, expecting prices to be lower in the future. This could lead to more stagnant economic growth, a significant shift from the country’s economic performance over the past few decades. 

To date, the government has not enacted significant policies to combat the economic challenges that have plagued the country throughout the year. The Peoples Bank of China, the equivalent to the U.S. Federal Reserve, has cut interest rates multiple times, but only in modest 0.10% to 0.15% increments. This has not been enough to induce consumers and corporations to take on more debt. 

Markets have reacted to China’s slowdown with a selloff in Chinese equities and sustained weakness in the Chinese Yuan. Year-to-date, the MSCI China index has lost roughly -5%, well behind the broader global market that has appreciated nearly +15%ⁱⁱⁱ.  Capital has left the country as international investors are electing to deploy capital in other regions. 

While this year’s erosion in the Chinese economy has been a surprise to us and many, we believe that softening conditions over the last eight months are not a sufficient length of time to indicate a substantial shift from the country’s past trend. There is no doubt that China has some structural challenges to work through. The housing market is overbuilt, and consumer balance sheets are overly reliant on the value of their home. While the intentions of the government aren’t clear, by not stimulating the economy to deal with current conditions, they may be electing to deal with the problem and sacrifice short-term economic growth in favor or building long-term stability. They have not done this during past episodes when the property market has softened, preferring to step in and prop it up. We’ll see if this time its different. 

The pessimism around the Chinese economy seems to have propagated to negativity of owning shares in the country’s stock market. Chinese equities do appear to be an attractive value at roughly 10x earnings, or half the valuation of U.S. stocks. However, there is the old market adage, ‘it may be cheap for a reason’ could apply here. From our perspective, despite more attractive valuations, we are reluctant to increase our exposure to Chinese equities until we have greater comfort that the structural issues within the economy have been eradicated. 

ⁱSource: Alpine Macro

ⁱⁱLazard Asset Management, https://www.lazardassetmanagement.com/us/en_us/research-insights/market-updates/china-too-big-to-ignore?utm_source=leadcontact&utm_medium=email&utm_content=investment%26%2345;research&utm_campaign=branding&platform=000000&emailcscode=WWX673473&sfdcid=0035f00001hHgXvAAK&salesEntity=LAMNY&salesTeam=RIA%20Sales&mkt_tok=Mzk0LU1MQy05OTcAAAGN5tbgiDCmQvC%26%2345;%26%2345;YRUPWWRAyX15Xx5H5W5AgdGytb56HK98_Tm%26%2345;klziiljtbxA45B6Q1_N_0taegrGTXTMG%26%2345;6ayiothxLWY98_dFLaPw

ⁱⁱⁱAs measured by the MSCI ACWI Index. 

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