By Reshma Kapadia
The nascent rally in Chinese stocks hit speed bumps this month. Whether the recovery can gain steam hinges on how China handles rising Covid infections, the continued slump in its property market and whether talk of restrictions on China and geopolitical saber rattling out of Washington, D.C. turns into action.
The iShares MSCI China exchange-traded fund $(MCHI)$ is up 15% from its late April low -- even after returning some ground this month as risk-assets broadly took a hit. Investors have been returning to China on the view the worst is likely baked into valuations, with China equity funds drawing $45 billion in net flows so far this year, according to EPFR Global.
Part of the draw has been the market's steep declines. Take the KraneShares CSI China Internet Pacer Swan SOS Fund of Funds ETF|ETF $(KWEB)$, a proxy for China tech. Its decline from a high in February 2021 to this spring, when Chinese policy makers indicated their crackdown on the sector was winding down matched the Nasdaq's full peak to trough decline during the 2000-2002 bear market, according to Jessica Rabe, co-founder of DataTrek Research.
The divergence in monetary and fiscal policy between the U.S. and China is also a draw. As European and U.S. central banks raise rates and try to tighten liquidity, Chinese officials are stimulating their economy with increased infrastructure spending and other measures aimed at healing consumer sentiment. That should help the economy, which barely eked out growth in the second quarter on official data, to recover, even modestly, as Europe and the U.S. slow.
But sentiment is fragile, leaving the rally vulnerable -- like to news earlier this month of fines against Alibaba Group Holding $(BABA)$ and Tencent Holdings (700.Hong Kong) that rattled investors who thought policy makers' vows China's regulatory drive was winding down meant no more news on this front.
While there could be more headlines about companies that run afoul of the new rules, some see these fines as a signal the tech crackdown is coming to a close."We believe the worst is over on the China regulatory side, but we still have implementation of the Holding Foreign Companies Accountable Act and the potential of delistings of Chinese stocks -- and the potential for the window for delistings to be shortened," says Brendan Ahern, chief investment of KraneShares.
Also worth watching: The push to increase scrutiny of China-related investments. Though a slimmed down version of the Chips Act aimed at bolstering domestic semiconductor production doesn't include a provision to create a mechanism to review certain outbound investments in China, Beacon Policy Advisors' Owen Tedford says the Biden administration may look to executive action to create such a mechanism in the fall. Still to be seen: The scope of such a measure -- and if it would create restrictions or just transparency.
Other clouds still loom. The economic hit from lockdowns in the spring had largely reversed in June, according to Capital Economics' China Activity Proxy, but Covid infections hit a two-month high as the virus hits more provincial areas. Though China is taking a more targeted approach to lockdowns, its healthcare system isn't set up for a large wave, especially with much of the elderly population unvaccinated.
Vivian Lin Thurston, a manager on the William Blair Emerging Markets Growth strategy, has been chipping away at an underweight position in China, buying Chinese stocks through the year as the market showed signs of bottoming and cities like Shanghai emerged from harsh lockdowns.
Among the stocks Thurston has gravitated toward are internet and consumer companies that have been beaten down and stand to benefit as China recovers from the lockdowns, and consumers get a boost from Beijing's efforts to stabilize the economy ahead of the 20th Party Congress when top leadership is selected.
As difficult as Covid has been to contain, China is having difficulty with its property market as well, with prices seeing unprecedented declines despite government support, the number of Chinese developers defaults piling up and homeowners refusing to pay their mortgages.
Thurston isn't that worried the property slump could turn into a systemic financial crisis in China, noting that only a quarter of first-time buyers use a mortgage. "If we see housing get iffy, then it will impact even those who don't have mortgages," she adds.
Indeed, BCA Research's Arthur Budaghayn warns: "In the past 14 years, the Chinese economy has never had a recovery without the property market because rising house prices and construction activity was the positive impulse to consumer and business sentiment."
Another challenge: The strong exports that have been a saving grace for China's economy could soften as the U.S. and European economies begin to slow. "The next leg for [Chinese stocks] is going to come from an earnings recovery," Thurston says. "Fundamentals need to stabilize and earnings need to come through."
Write to Reshma Kapadia at reshma.kapadia@barrons.com
$(END)$ Dow Jones Newswires
July 21, 2022 13:14 ET (17:14 GMT)
Copyright (c) 2022 Dow Jones & Company, Inc.
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