China: no systemic financial risk, but lower long-term growth

In recent weeks, missed debt repayments by another major property developer and one of the largest shadow-banking institutions have triggered fears of systemic financial risks in China. In our view, however, such concerns are overblown due to the Chinese banking sector’s limited direct exposure to property developers and the relatively small (and shrinking) size of shadow banking activities. In addition, the authorities have taken action to alleviate the acute liquidity stress in parts of the private sector and at some local governments.

While we do not expect a financial meltdown, the property slump will likely cost the Chinese economy in terms of long-term growth potential, primarily because of a sharp slowdown in investment. The expected deceleration in fixed-asset investment, combined with other headwinds such as deteriorating demographics and de-globalisation, have led us to revise down our long-term growth expectations for China earlier this year. After the post-covid rebound, we now expect China to grow by about 4% in the next few years (80-90 bps lower than our previous forecast in 2022) and we believe China’s annual growth potential may decline to 3.7% in 10 years’ time.

Turning to the Chinese equity market, despite low valuations (with 12-month forward price-earnings ratios of around 10x and 11.7x for offshore and onshore stocks, respectively), which look even more stretched on a sector-adjusted basis, investors are clearly not queuing to pile into Chinese stocks. The earnings picture, too, remains unappealing, as growth expectations remain too high and revisions have turned steadily negative, particularly in USD terms.

Although the overall picture looks grim, the prevailing bearishness around Chinese equities makes them ripe for a rebound at some point. While valuations are rarely a reliable indicator in the short term, positioning can be. Managers of emerging-market funds currently hold an average 4% underweight on Chinese equities versus their benchmark, which is high by historical standards. Outflows from Chinese equities have been very high recently.

All things considered, we have decided to maintain our exposure to Chinese equities and our overall neutral stance on EM Asian equities. While we would refrain from betting on government stimulus having a lasting impact, the recently announced policy measures combined with weak positioning and low valuations hold out the possibility of some upside potential. We have revised down our target for the MSCI China to HKD65 (from HKD76 set at the beginning of the year), driven by a slight downgrade in valuations and high single-digit earnings growth.