Investment thesis

In this article, I explain why I think a V-shaped recovery is very unlikely to happen in 2022 for the Chinese economy. Despite the excellent returns of Chinese equities since April 2022 compared to other emerging markets, I believe the political risks associated with the zero COVID policy, combined with a delayed recovery in the housing market, will hamper the country’s short-term economic outlook. Unless the Chinese government provides meaningful stimulus on the demand side over the next two months, I expect the economic recovery to remain slow with downside risk stemming from a global recession. Accordingly, I continue to believe that the safest way to gain exposure to China at present is to use long-term call options where the investor only risks losing the premium paid for that.

What has happened since my last post

I concluded my previous article on the Invesco Golden Dragon China Portfolio ETF (NASDAQ: PGJ) with the following statement:

Chinese stocks are trading at around 11 times forward earnings, which is well below the 25-year average multiple and much cheaper than what you can find in developed markets right now. Additionally, China is now pushing for expansionary monetary policy, which should be supportive for equities going forward.

It turns out that Chinese stocks have outperformed emerging market stocks since I wrote this article. I compared PGJ’s returns over the previous three months to those of the iShares MSCI Emerging Markets (EEM) ETF to determine which was a superior investment. PGJ outperformed EEM by around 25 percentage points, which is a fantastic return when annualized.

Despite positive returns, investors have begun to withdraw some of their exposure to China in light of geopolitical tensions. The war in Ukraine and the Taiwan issue have polarized nations, and investors now have a better understanding of the implications of their investments. Foreign equity exposure to Chinese equities has shrunk by almost a trillion yuan since December 2021, representing a decline of around 20% from the peak. In my opinion, this could only be the start of this trend considering the direction the world is heading. A more polarized world will likely be one where investors face legal hurdles, such as sanctions imposed by Western countries on Russian stocks.

The Chinese real estate sector

The main issue a few months ago was the bursting of the Chinese housing bubble. Although this is a less covered topic than 6 months ago, I still believe it remains of paramount importance in understanding where the Chinese economy is today. In my opinion, this bubble is still unfolding. As the mounting pressure in the credit market shows, the real estate issue now appears to be spreading from bankrupt developers to healthier developers, as illustrated by their bond prices which have been actively sold over the past few years. last weeks.

On top of that, real estate prices are starting to be a major issue in China. Since the Chinese real estate market has been in surplus for years, the only mechanism in place to correct the imbalances between supply and demand is a readjustment of real estate prices. Needless to say, this becomes problematic for the CCP as it creates massive discontent among households who have seen real estate as their only available vehicle to park their excess savings. To avoid this, some Chinese cities have opted for price caps, but without real readjustment, the real estate issue may last longer than expected. Some cracks are already beginning to appear in the secondary mortgage market, where borrowers are outright threatening to stop repaying their loans.

In response to demand pressures, real estate developers are suspending work on an increasing number of home construction projects, as illustrated by the growing gap between new project pipeline growth and actual construction activity. That gap is now at its widest in a decade. According to a central bank official, China will set up a real estate fund to help real estate developers solve this problem. The price to pay for that? A measly ~300 billion yuan ($44 billion) to boost a multi-trillion dollar industry. I personally believe that much more support is needed at this time.

Domestic consumption remains a problem

In addition to the Chinese real estate crisis, the zero Covid policy is definitely adding fuel to the fire and weakening domestic consumption. Chinese retail sales fell -11% in May 2022 from the same month last year, well below analysts’ estimate of -3%. Despite the fact that year-on-year retail sales have recovered and are now showing positive growth, the country continues to post one of the largest trade balance surpluses as a percentage of GDP in its history. There haven’t been many headlines showing significant demand-side stimulation in China at a time when it needs it most.

The lack of stimulus in a sluggish economy is reflected in consumer confidence data, which has reached abysmal levels in recent months. Until we see a clear reversal in this trend, I think China’s growth will be slower than what we have been accustomed to over the past decade.

Another damage caused by the real estate crash and the zero-Covid policy is found in the labor market. The unemployment rate in urban areas reached a record high of around 6% in May 2022, before slowly coming down. That said, urban unemployment still remains well above the historical average of ~4.8%.

The situation is particularly bad among young workers where unemployment soared to almost 20% in June 2022.

Unsurprisingly, year-on-year growth in domestic loans hit multi-decade lows this year. Amid unfavorable economic conditions, Chinese investors’ risk appetite is waning, despite lower interest rates. Overall, I think a V-shaped recovery in 2022 remains unlikely. Therefore, I continue to believe that the best way to gain exposure to the Chinese economy is to use long-term call options.

Key points to remember

Despite the excellent returns generated by Chinese equities since April 2022 compared to other emerging markets, I believe that the country’s short-term economic prospects will be hampered by the political risks associated with the zero-COVID policy, combined with a delayed recovery from the estate market . Unless the Chinese government offers significant demand-side support in the coming months, I expect the economic recovery to remain weak, with the prospect of a global recession looming. As a result, I continue to believe that the safest approach to gaining exposure to China at present is to use long-term call options, where the investor risks losing only the premium paid for it.