The China Reopening Factor
Sébastien Page
Head of Global Multi-Asset and Chief Investment Officer at T. Rowe Price | Author: “The Psychology of Leadership” (Harriman House)
China’s change of course doesn’t make me a bull, but I’m a bit less of a bear
A key trait of successful investors is an awareness of the limits of their own expertise. So let me say that I’m not an expert on China. Luckily, as with many things around here, I’m surrounded by people who know a lot more about the subject than I do. Our investment staffs in Hong Kong, Shanghai, London, Baltimore, and elsewhere are constantly monitoring developments in the world’s second-biggest economy and its stock market.
China’s rapid relaxation of its zero-COVID policy has been a surprising development that has boosted global investment sentiment. The government has also relaxed lending curbs on developers, which should help its struggling property sector, and loosen credit in other ways. As a result, China is likely to be the only major economy that accelerates in 2023.
Avoiding the stampede
There’s little doubt that China’s re-opening bodes well for the global economy—and perhaps for stocks. Growing demand in China might help compensate for falling demand elsewhere; although it could also prolong inflationary pressures (see one worry for airfares below). Indeed, China’s economy is a major factor driving financial markets globally.
While events in China seem to have fed a global rally to start the year, opinions vary within our Asset Allocation Committee about whether it will help bring about a durable market recovery. One of our bulls sees “an almighty change of direction” in the regulatory environment, for example, but some of our bears look at valuations and think the recent rally has left markets overextended. “We’re one bad CPI away from a meltdown,” said a committee member during our most recent debate. While during 2022 we had a strong bearish consensus, China’s rapid reopening has reignited the debate between the bulls and the bears on our committee.?
Finding untrampled ground
While there is a range of views on the team about what lies ahead, and the gap between the bulls and the bears has seemingly widened, we remain contrarian. Our goal is to take advantage of relative valuation opportunities. If some opportunity arises that everyone can see—and China’s turnaround is hardly a secret—we don’t follow the herd into the stocks, sectors, or markets that stand to benefit immediately.
Markets are largely efficient, in other words, so the good news is quickly incorporated into stock prices. But all of us on the committee firmly believe that markets are not perfectly efficient—and that’s where we can try to find where the good news on China may not yet be reflected in asset prices. We tend to look beyond direct beneficiaries of China’s reopening, such as global commodities, to find indirect or second-order beneficiaries.?
How should China’s opening affect our allocation decisions?
To evaluate where we might find some of these opportunities on an asset-class level, and to evaluate the appropriateness of our current positioning, I called upon the help of some colleagues: quantitative investment analyst Grace Zheng, Asset Allocation Committee cochairs Charles Shriver and Dave Eiswert, and real assets portfolio manager Chris Faulkner-MacDonagh.
In order to see what the likely impact of China’s reopening might be on the relative appeal of various asset classes, the team and I built what we call a “China Reopening Factor.” It sounds complicated, but bear (no pun intended) with me.
Three of the variables in the factor together make up half of the model and correspond to global commodities directly impacted by China demand: copper, iron ore, and jet fuel. If you have any doubts, look at what has recently happened to the price of the last one.
Faster growth in China has a much broader impact, of course, and it benefits the global economy in myriad other ways—and vice versa for slowdowns, such as last year’s. The other 50% of our China Reopening Factor uses changes in DeepMacro’s “nowcast” as a point-in-time estimate of China growth activity.1
We then examined how asset classes have responded to our China Reopening Factor. These are trade-offs that we consider constantly—investing more in this means investing less in that, all else being equal.
We examined the relative performance over the past six years (from January 1, 2017, to January 16, 2023) of the following:
This lets us see how stronger growth in China might be expected to impact the relative performance of bonds versus stocks, for example, or high yield versus investment-grade bonds.
Finally, we looked at how the recent upswing in growth expectations has impacted the relative performance between each asset class pair. The difference between expected and actual performance indicates potential mispricing—and thus the directions in which we might tilt our allocations.
What we learned
Our takeaways? China’s apparent turnaround supports our current overweights in small-caps and high yield. Both are risk-on bets, and we believe a rebound in China’s energy demand should support energy prices and, therefore, the fundamentals of high yield energy issuers, which make up a large portion of the high yield bond market. These results also support our decision to add moderately to our equity allocation—although we still remain underweight.
As noted above, opinions on the Asset Allocation Committee vary. Speaking for myself, let’s just say that I’m still somewhat bearish, but my inner bull is stirring.
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References
1 DeepMacro, LLC. DeepMacro’s China Growth Factor is a point-in-time estimate of activity from a dynamic factor model that “nowcasts” growth using series across labor market, industrial production, PMIs, electricity consumption, and consumer surveys.
Important Information
The views contained herein are those of the author as of January 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price companies and/or associates.
This information is for informational purposes only and not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types; advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. There is no guarantee that any forecasts made will come to pass. The chart is shown for illustrative purposes only.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks.
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