Chinese equities witnessed a 30% reopening rally from the end of November 2022 to the end of January 2023, only to lose half of that gain by the end of April, mainly driven by investor disappointment at the pace of the reopening recovery.
We don’t think that China’s ‘reopening momentum’ has run out of steam. Rather we believe that investors can still benefit from cheap valuations, low interest rates, and government measures seeking to boost domestic demand.
"The end of lockdowns is seeing Chinese consumers coming back to more outdoor activity, especially as the government is encouraging people to be more active."
A number of Western companies blamed weak first quarter results on a slower than expected bounce from China’s reopening (see FT: Western companies warn of hit from China’s slow recovery, May 7, 2023). We believe that the lack of a first quarter bounce should not have come as a surprise. After prolonged lockdowns, inventory has been building in retail channels, and goods have piled up in consumers’ homes, and this would need to be cleared before selling rates reach the levels that would once again reflect underlying consumption demand.
Consumer demand starting to return
Some signs are indicating that consumer demand is returning. Adidas, for example, recently stated that it was seeing a ‘positive trend’ in China, despite reporting first quarter revenues in the country that were down 9%. The German sportswear company said that its weak sales reflected the clean-up of inventory that was taking place, particularly third-party distribution channels. To understand underlying demand trends, investors need to look at ‘sell out’ data. This records only sales to the ultimate consumer and is indicative of consumer demand without the distortion due to stocking or destocking. Sell out data shows sales were up in all channels, and up double-digits in Adidas’ own stores. The end of lockdowns is seeing Chinese consumers coming back to more outdoor activity, especially as the government is encouraging people to be more active.
A similar trend was noted by the cosmetics giant L’Oréal, which highlighted the impact of destocking in China driving negative sales growth in both December and January. However, by February and March, once the inventory in the channels had started clearing, growth had bounced back to double-digits.
According to JD.com, a Chinese e-commerce giant, recovery in consumer demand has been more muted in big-ticket categories such as electronics and home appliances and other durable goods, lagging behind categories such as catering and entertainment. But as of April, the recovery in even these big-ticket categories had been picking up.
Chinese consumer confidence has turned a corner from its most depressed level, not only since the GFC but in fact for the past 30 years. This helps to explain the demand support for bigger-ticket items, as JD.com highlighted.
As we progress through the second quarter, we expect to see further strengthening of demand from consumers as COVID moves into the rear-view mirror.
“With youth unemployment around 20%, the Chinese government should be motivated to keep regulators from interfering with entrepreneurial companies.”
Xi prioritises recovery and expansion
The regulatory reset for Chinese tech companies two years ago brought to the forefront of investors’ minds how government policy can derail the recovery. Despite this being a high-materiality risk for investors to consider, we see the probability as relatively low at this point in time. President Xi Jinping said at the Central Economic Work Conference last December that “China must give priority to the recovery and expansion of consumption in 2023” according to an excerpt published in the Communist Party magazine, Quishi.
With youth unemployment (ages 16-24) around 20%, the government should be motivated to keep regulators from interfering with entrepreneurial companies that can help bring down unemployment. Xi highlighted his support for private companies that account for 90% of urban employment and the majority of new jobs, innovation and wealth creation.
Xi was even more explicit in his promise to reduce regulatory interference in the tech sector by underlining the need to support platform companies in leading development and creating jobs.
Geopolitical risks factored in
International investors are also cognisant of geopolitical risk when it comes to investing in China. We believe that this could continue to cause volatility in Chinese equities. Although US Treasury Secretary Janet Yellen took a more constructive approach in a speech on April 20 stating that the US seeks “a healthy relationship with China: one that fosters growth and innovation in both countries”, this did not appear to help sentiment much.
We believe that this geopolitical risk is already factored into the current depressed valuations. China trades on a forward Price/Earnings multiple of 10.2x, which is 1 standard deviation below its 5-year average, despite the depressed earnings.
Investors looking for opportunities as the Chinese economy reopens should, we believe, focus on companies that provide products and services that meet Chinese consumers’ demands. Businesses which depend on domestic consumption should also be less impacted by geopolitical tensions. Although there should not be a significant geopolitical impact on their future cashflows , stock prices may continue to suffer in the short term from market volatility, creating an opportunity for investment by active, fundamental investors.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Trinetra Investment Management LLP and are subject to revision over time. Trinetra is authorised and regulated by the Financial Conduct Authority in the United Kingdom.