China Market Outlook 2024

Investing in China in 2023 can be characterized by an initial optimism surrounding the post-COVID reopening that was tempered by the sobering reality of both external and internal challenges that drove the Chinese indices' underperformance relative to its regional peers this year.

Externally, the pace of decoupling from China and Sino-U.S. tension appeared to have accelerated over the year. Most notably, we have seen a clear relocation of the supply chain to Southeast Asia, India, and Mexico as companies seek greater economic and political stability. This has partially led to China’s soft exports and foreign direct investment, which we believe could be more structural than a short-term trend. Additionally, the US appears to be committed to preventing China from obtaining advanced semiconductor technology and equipment, thereby hindering China’s progress in high-tech advancements such as AI.

Internally, the lack of large fiscal stimulus to support the housing market and consumption demand has led to weak consumer sentiment coupled with an elevated youth unemployment rate. Although the central government has taken various measures such as removable of home purchase restrictions, lowering downpayment ratio and mortgage rates, and the recent announcement of an additional RMB 1 trillion Treasury Bond to local governments, these measures have largely met with a neutral reaction from the investment community given that they do not entirely address the underlying challenges surrounding the properties market and the local government debt, which remain the key overhangs to the macro recovery.

Heading into 2024, we believe several trends and themes are worth monitoring:

First, the state of the property sector remains the single biggest directional determinant of Chinese equities. China’s property market currently faces a combination of challenges including over-leverage, unfinished housing, and waning demand due to population decline. Many of the fiscal policies in the sector have been fractional rather than decisive and the market will look for signs or progress of any decisive measures to address the property market risk to avoid the potential contagion risk. While we believe the government’s decision to not pursue large stimulus in the property sector to be the right decision in shifting the country’s economic reliance away from the problematic sector, we also note that the current measures only address the symptoms of the challenge rather than the underlying issues. In our view, unless the underlying issues can be resolved either through centrally planned or the existing methods of state-owned enterprises, Chinese equities are likely to trade sideways in the foreseeable future.

Second, the structural decoupling from China is likely to accelerate. If there is anything multinationals have learned over the past three years operating in China, that would be low-cost labor should no longer be the leading determinant of business continuity. Economic and political stability matters more. While China has a more efficient manufacturing infrastructure, supply chain, and abundant workforce, these factors are the product of decades of foreign direct investments and theoretically can be replicated elsewhere with a sufficient amount of investment. As such, nearshoring to countries such as Mexico, where companies enjoy proximity to the US market and free trade, has proven to be an appropriate alternative to China. We expect more multinationals to accelerate this trend and this shift could negatively impact China’s manufacturing sector and exports. On the flip side, this trend could also accelerate China’s shift towards high-tech, industrial automation, and consumption-oriented economy. Whether the puts and takes can offset each other perfectly in tandem remains unseen, but the trajectory is there.

Third, affordable luxury and frugal living will be a hallmark of the Chinese consumption theme. The economic uncertainty, diminishing wealth effect, rising unemployment, and lying flat amongst the young working-age population are all driving the shift towards maximizing affordable luxury within the consumption means. We consider this a shift towards “consumption selectivity” where consumers are looking to maximize the economic value of every transaction rather than a “trade down” or a “consumption downgrade”. Rather than pulling back on spending, consumers are becoming increasingly savvy in their purchase intentions, which benefits the retail channels and brands that have the flexibility of meeting consumer demand under this new consumption scenario. For example, coffee has always been considered a luxury beverage in China, but Luckin can offer greater value of money coffee beverages to a nation that is more accustomed to drinking tea. This not only allows Luckin to capitalize on the pursuit of affordable luxury amongst Chinese consumers but also maintain steady revenue growth in a market that is faced with multiple uncertainties.

Fourth, the US election outcome is unlikely to change the status of Sino-US tension. The US and China share more differences today than they did a decade ago and this sentiment is unlikely to change given that “de-risk” from China is the single biggest consensus amongst both political parties in the US. If we look at the semiconductor ban that has been ongoing for the past year, we can conclude that the US has a uniform approach when it comes to limiting China’s technological advancement, particularly in AI, and the recent update to the semiconductor export ban is consensus amongst both political parties and across national agencies such as the Department of Defense, the Central Intelligence Agency, the National Security Agency, and the Department of Commerce. This level of inter-party and inter-department consensus is rare in US history and illustrates the resolve of the US to prevent an equal playing field with China in terms of advanced technology. On the surface this may be perceived as a negative, we, on the other hand, consider this to be another positive given it could accelerate indigenous innovation within China, and that could be a source of investment opportunities in the near term.

Finally, more Chinese firms are likely to accelerate the globalization trend. The soft domestic market calls for Chinese firms to increasingly look to the global market for a source of growth. Our view on most Chinese companies is that many have benefited from the rising consumer class over the past decades under a “volume-driven” model rather than a “value-driven” or “innovation-driven” model. Given the population has largely peaked, these companies can either seek higher value or innovation for growth or ex-China for incremental volume-based growth. Regardless of value or volume, we see Chinese companies that are not “lying flat” are the ultimate beneficiaries. For domestic-focused companies, moving up the value chain can elevate their brand status and take share from the multinationals. The companies that pursue growth outside of China, can compete against the larger foreign players and become truly global Chinese companies. The trajectory to become a global player is not linear but not impossible. We note that Tiktok, Shein, and PDD Holdings are some successful cases, and we are positive that more Chinese firms will follow.

Despite the lack of meaningful consumption-oriented stimulus by the central government, coupled with the ongoing investor pessimism and potential structural de-rating, which poses a formidable challenge when investing in Chinese equities, we also believe the current valuation level poses an attractive opportunity for medium to long-term investors with MSCI China trading at a significant discount compared with MSCI US.

All in all, we continue to believe that China offers investors attractive opportunities despite the near-term sentiment and the challenges. The key is to be selective in identifying the potential winners that could become the next domestic champion or emerging players capable of competing at a global level. Thematically speaking, we prefer Chinese companies that can compete effectively on a global scale, “affordable luxury” brands that can capitalize on the consumption selectivity trends shaping across China, and niche emerging leaders within consistent free cash generation and growth profile that can withstand the macro volatility.