1. What are some of the key macro factors EM investors should consider when it comes to China?

According to official statistics, China’s real GDP grew by 5.2% in 2023. At the recent March National People’s Congress (NPC) meeting, China sets its 2024 GDP growth target of around 5%, which is identical to 2023 target. So far, the market’s reaction has been skeptical, calling the growth target overly ambitious. Nevertheless, it signals a more proactive policy stance.  From an investment perspective, we take the view that whether China will meet its target this year is less important than the path and policy choices made along the way.

If we start from the top, in Xi Jinping’s desire and pursuit to become the emperor of China, we believe his objectives and priorities have shifted. He thinks more about his party inner circle loyalists than the Chinese consumer; he thinks more about the security of his regime than broad economic growth.

The potential consequences are: first, there can be confusion around what Xi actually wants regarding economic policies. In December of last year, we saw a short-lived announcement on video gaming regulation which triggered an $80 billion selloff in China’s gaming market in one trading day. This selloff resulted in the top gaming regulator getting fired and the administration walking back the announcement. Second, the quality of Xi’s economic policy makers is questionable in that the most qualified and capable people for the job may not be appointed in exchange for political alignment. Therefore, economic policymaking tends to be sub-optimal.

This partially explains why monetary policy, faced with deflation, has been tight until recently. Furthermore, despite the narrative around rebalancing from an export-driven to a consumer-driven economy, we do not see any significant data supporting this transition. Given low consumer confidence, we do not see impactful wealth transfer-related policies. While rebalancing a big economy is difficult and takes time, it is debatable whether China is genuinely pursing rebalancing to further empower consumers from current wealth levels.

Therefore, we are still seeing more supply side stimulus than demand side stimulus, leading to overcapacity in certain industries. While property investment has declined dramatically, manufacturing and infrastructure spending are still rising fast; thus we expect China’s trade surplus to persist. One of our current investment themes is the petrochemical sector. As a result of a large supply of Chinese petrochemicals, the profit margins and cash flows in this sector are compressed globally. Many emerging market corporates in this sector are struggling in countries including India, Brazil and Mexico. We are waiting for the oversupply to clear for these corporates to recover, and risk premiums to compress as a result.

Having said the above, we are less worried about China’s aggregate economic growth this year, nor do we think China cares about the growth level as much as the quality of growth. Historically, China has had a strong track record when it comes to targeted industries: currently they are targeting renewables and technology. In the NPC meeting, the focus was on developing the “New Three” for high quality growth. The new three being electric vehicles, lithium-ion batteries and renewable energy products such as solar panels and wind turbines. Indeed in 2023, these three sectors have experienced a surge in investment of almost $900 billion USD. [Source: Centre for Research on Energy and Clean Air (CREA)]

2. How has global macroeconomics impacted credit trends in China? How are you positioned against these trends?

In December 2023, Moody’s changed its outlook on China’s sovereign rating from stable to negative, while still affirming China’s A1 rating. The outlook change was due to two areas of concern: first, the ongoing real estate sector correction and the pressure it has caused in adjacent industries like Local Government Financing Vehicles (LGFV); second, China’s medium term growth outlook, which is faced with a declining labor force, maturing capital stock and only moderate productivity growth. The sovereign rating change has caused immediate pressure on some investment grade (IG) names due to the sovereign ceiling policy, which typically requires corporate ratings to remain at or below the sovereign rating of their country of domicile. Given that these concerns are unlikely to go away anytime soon, we think China’s sovereign rating will remain a risk factor to credit trends.

If we look at the data within Asia IG corporates, China real estate and LGFV have accounted for 80% of the ratings downgrades in 2023. In the same time frame within Asia High Yield (HY), China real estate accounted for 50% of the downgrades. Therefore, it is evident that real estate and its related sectors have remained the weakest link. Furthermore, we do not believe we have seen the bottom of this trend. Currently within the real estate sector, 40% issuers are rated BBB and 30% issuers are rated CCC. Six out of eight BBB rated issuers in the real estate sector are either on review for downgrade or on negative outlook. [Source: J. P. Morgan research]

It’s important to note that away from real estate, credit trends look more attractive. Macao gaming is seeing sectoral upgrades across issuers due to its ongoing positive structural shifts, such as a shift from junket-led to premium mass-led business models, increasing Gross Gaming Revenue (GGR) as a result. The aggregate data of Chinese corporates also show that, excluding Chinese real estate, the negative credit trend had already peaked in 2022.

However, despite the credit landscape looking much more promising away from the real estate sector, some permanent damage has been done. As an offshore bond holder, confidence regarding where we are in the payment pecking order and China’s incentive to pay off offshore bond holders are compromised. Furthermore, there is the gap risk in Chinese IG credit. An IG issuer can experience large bond price volatility overnight, sometimes due to unforeseen regulatory headlines, sometimes without a holder knowing for certain the exact cause, due to the opacity of domestic technical factors.

Therefore, when it comes to investment positioning we have a bias towards quality and towards corporates with offshore assets. 1) We prefer IG over HY. In additional to quality advantages, IG issuers can refinance more easily via domestic channels. Domestic bonds in China typically have shorter maturities of less than 3 years. Therefore it is harder for HY corporates to keep a sustained level of debt issuance domestically. 2) Within IG, we like sectors that are more aligned with the new growth mode, such as the Technology, Media and Telecommunications (TMT) sector. 3) We prefer State Owned Enterprises (SOEs) to Private Owned Enterprises (POEs). SOEs have stronger market positions and better support. We expect Xi Jinping’s objective of “Common Prosperity” to lead to stronger SOEs in the economy. 4) Not all SOEs are the same. Within SOEs, we prefer those that have stronger standalone credit metrics, strategic importance and parent support.

3. Are there any particular sectors in China that you are monitoring closely?

We are keeping a close eye on China’s TMT sector. It is a sector that is strategically aligned with China’s new growth model and targeted industries. However, it is also the sector that is rather exposed to the US-China relationship. Therefore, it is a sector that has political, economic and investment importance. 

From an investment perspective, the TMT sector has dispersions within but overall it offers defensive characteristics, which we believe may lead to outperformance against the broader Asia IG space. The sector is experiencing strong investments in order to achieve China’s goal of self-sufficiency. We expect the construction of hard technology infrastructure to accelerate, such as artificial intelligence (AI) and 5G. We also expect continuous development of instant-delivery online retail and e-commerce platforms, which are key marketing channels for China’s consumer sector. Nevertheless, the competition is fierce and we expect companies that can afford to maintain heavy capital expenditures (Capex) to expand production capacity and increase their market share will outperform.

If we look at China AI more specifically, leading companies in this space have been developing AI since 2000 but the monetarization may finally start this year, such as using AI to enhance product offerings in advertising and the cloud. The Capex should remain large for these companies while free cash flows continue to show strength, standing at around 4 times expected Capex for 2024.  

US-China geopolitical tension is the biggest headwind to China’s technology progress over the long term. For example, exports of some advanced computing chips to China are currently banned. The upcoming US election will remain as an overhang that prevents us from being overly bullish on China’s TMT sector. However, we take comfort that some companies have exceptionally strong standalone balance sheets with negative debt, have stockpiled enough chips for the next couple of years and offer a valuation pickup relative to similarly rated peers in developed markets. 


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