Emerging Markets Equities

What’s next for China?

June Lui, Portfolio Manager, BMO LGM Investments, gives an on-the-ground assessment of China’s economic backdrop and the impact on stocks.
April 2020

As the first country to tackle COVID-19, China has institutional investors globally wondering about the local situation – and what it means for their portfolios. June Lui, Portfolio Manager, BMO LGM Investments, gives an on-the-ground assessment of China’s economic backdrop and the impact on stocks.

Ahead of the curve

In this impossibly low-yield environment, many institutional investors are looking for buying opportunities. Should they be turning their attention to China? With the first case of COVID-19 documented in China back in December, the country – unlike Western nations currently in the thick of the crisis – is gradually recovering and resuming ordinary activities. The question remains: how fast is China getting back to work?

The China PMI index – a leading economic indicator of trends in the manufacturing and service sectors – fell from 50 to 35.7 in February, and then picked up to 52 in March, easily topping expectations and signaling a broad stabilization of business conditions.1 Apart from macro data, based on our own meetings with companies on the ground, factories in most regions outside Wuhan have restored their commercial capacity to 90% levels as at the end of March, which compares to 60% to 70% at the end of February.2 However, while capacity resumes, actual output is still below the pre-virus level, since consumption and demand have yet to fully recover, in large part due to the developing pandemic situation globally. Despite the push toward domestic-led growth, exports still account for roughly 20% of China’s gross domestic product (GDP), which is a significant portion of the economy. Enterprises recovered strongly in March because of rush restocking demand, yet there is some uncertainty ahead because of the current predicament outside China, which will make visibility here more difficult for the short term.

The key point for us – which is fueling Chinese confidence now – is that with the COVID-19 outbreak appearing to be well past its peak, the government’s policy and resources are pivoting away from containing the virus, and toward restarting the country’s growth again.

While information at the corporate-level is still largely anecdotal at this point, our team at BMO LGM Greater China has “virtually met” with many companies recently, and most have already restarted production as the economic data suggests, while awaiting a pick-up in demand. They are optimistic this will correct once the pandemic situation improves. Businesses are also taking additional precautionary measures, including extra accommodation for migrant factory workers, scheduling changes to avoid high density situations and further disinfectant supplies, which will unsurprisingly increase operating costs. It’s likely that most will experience working capital stress as receivables grow, but China’s banks will probably fill the gap here.

The key point for us – which is fueling Chinese confidence now – is that with the COVID-19 outbreak appearing to be well past its peak, the government’s policy and resources are pivoting away from containing the virus, and toward restarting the country’s growth again. How does this macro outlook impact Chinese equities?

Chinese equities: Resilience for the win

Chinese equity markets have been surprisingly resilient since the outbreak, with only a few days of large declines after which stocks recovered. In fact, the Shanghai Composite Index was one of the best-performing markets in February, March and April globally (as shown below), and that’s partly due to the progress made in the resumption of economic activities; the flattening of the virus curve; and the expectation of additional government support, both from a fiscal and monetary perspective. So far, the People’s Bank of China has kept the powder dry (as opposed to the U.S. Federal Reserve) and benchmark rates steady, while releasing extra liquidity through the reserve ratio requirement cut. The expectation is that the central bank will take whatever steps necessary to keep the economy from slowing, on top of a raft of fiscal measures to provide credit and tax relief to local companies, especially small businesses. As a result, both institutional and retail investors have been actively participating in Chinese equities, with market turnover quite strong. While it may seem counterintuitive to some, the outbreak could be eliciting a new wave of opportunity for fundamental active managers – especially as growth stabilizes.

Strength in isolation: China stocks hold steady while rest of world tumbles

Whats next for China - Strength in isolation - China stocks hold steady while rest of world tumbles - Chart

Source: Bloomberg, April 20, 2020.

What does the future hold for China?

It’s crucial to look beyond the short-term volatility because as history dictates, the world will eventually recover from the pandemic, and China’s economy will be revived. For long-term investors, China is rife with opportunities: it’s an ideal hunting ground for inexpensive growth exposures, particularly in sectors driven by domestic trends, including health care and environmental protection. Before COVID-19, U.S. valuations were overextended, whereas Chinese equities continue to provide an attractive – and effective – means to diversify portfolios and enhance construction.

Price to earnings ratio of major markets – China offers the best value for growth

Whats next for China - Price to earnings ratio of major markets - China offers the best value for growth

Source: Bloomberg, April 20, 2020.

For long-term investors, China is rife with opportunities: It’s an ideal hunting ground for inexpensive growth exposures.

The recent inclusion of 472 large- and mid-cap China A-class shares in the MSCI Emerging Market Index means Chinese equities will represent a bigger slice of global markets. As a result, asset managers and owners worldwide will have to seriously consider how to increase their exposures to China. The country, which contributes nearly 20% of world GDP and is home to the second largest equity market in the world, has been notoriously underrepresented in global investor portfolios. While greater index weighting for China is a positive development in totality, the need for an active strategy led by a global investment team has never been stronger. Many investors simply assess what the benchmark composition is, and allocate accordingly, but this has been slow to reflect the opportunity set available within Chinese markets. Indexes tell you about the past, which is why companies, countries and sectors that have already done well tend to dominate the index, whereas investing – in its purest form – is about the future.

Part of our comprehensive process is to have a seasoned investment team on the ground, speaking the local languages and gathering firsthand information for thoughtful asset allocation decisions. After all, China is still an emerging market that carries inherent risk – from lack of transparency to corporate governance issues. Therefore, it’s vital that institutions are selective in choosing capable managers: BMO LGM Investments is focused on bottom-up quality and alpha generation for the long term, with the expertise to uncover exciting investment opportunities that we believe can survive throughout the cycle, and add true diversity to your global portfolios.

Disclosures

1 China Manufacturing Purchasing Managers Index (PMI), Investing.com  

2 BMO Greater China Class Update, BMO Global Asset Management, March 2020.

The investments and investment strategies discussed are not suitable for, or applicable to, every individual.

Investing in emerging markets can be riskier than investing in well-established foreign markets.

Diversification and asset allocation do not ensure a profit or guarantee against loss. Past performance is not a guarantee of future results.

Dow Jones Industrial Average (Dow) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

MSCI Emerging Markets Index is a market capitalization weighted index comprised of over 800 companies representative of the market structure of the emerging countries in Europe, Latin America, Africa, Middle East and Asia.

Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region.

MSCI AC Asia Pacific Index captures large and mid cap representation across 5 Developed Markets countries and 9 Emerging Markets countries in the Asia Pacific region. With 1,587 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Investments cannot be made in an index.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

Views and opinions have been arrived at by LGM Investments, a part of BMO Global Asset Management, and should not be considered to be an investment recommendation. The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

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