The Factory Daily Letter

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Can China continue to outperform?

The longer-standing risks remain, but the short-term outlook just got brighter

Over the past few weeks, major equity markets have been shaken by ongoing evidence of the more persistent than expected nature of inflation, the aggressive nature of central bank policy tightening that is being put in place to meet it, and the associated fear of recession in the months to come. As we discussed in our Technical View on Tuesday “From inflation concerns to recession fears, the hawkish shift now evident across central banks has been stoking recession concern, particularly in the US and Europe, and sending many equity markets (including now the S&P500) technically into bear market territory - the fear being that aggressive rate hiking cycles make for much more diminished growth prospects.

Chinese equity markets have suffered much more than their US and European counterparts in the first half of this year. Yet, this may have changed recently

Over the past twelve months, Chinese equities have been up against several headwinds, not least the country's heavy-handed Zero-Covid Policy which sparked the reinstatement of several lockdowns (particularly in the Shanghai area) that have weighted heavy on the macroeconomic environment and kept the pressure on global supply chains. Investors progressively reduced their exposure to Chinese equities as economic activity slowed – ongoing lockdowns and the country’s property sector problems driving risk-aversion further. This while regulatory crackdowns continued to put further pressure on Chinese corporates – notably those listed on US exchanges (ADRs) with tech and internet companies taking the brunt, the result being (as we discussed back in March) that many were knocked down to significant discount territory vis-a vis those listed only in China.

However, Chinese stocks have more recently been outperforming those of US, EU and Japan, as is illustrated in the chart below (which shows the year-to-date performances of the MSCI China, Nikkei 225, S&P 500 and STOXX Europe 600, rebased at 100). In late April, the progressive easing of lockdowns, pledges from the Chinese authorities to provide further support to the economy, and an apparent pause in the stream of new corporate regulation appeared to alleviate sentiment. On the basis that the Chinese authorities continue to appear willing to step up their efforts to mitigate the economic deceleration brought on by the strict imposition of zero-Covid, Chinese equities could continue to outperform in the near term on hopes (and further evidence of) more fiscal stimulus, policy support, less regulation risk and the easing (and ultimate lifting) of lockdowns. 


Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

Global markets are fixated on inflation – and inflationary pressures remain relatively muted in China

With headline inflation edging to 2.1% in May compared to a year ago, China appears to remain relatively immune – along with Japan – to the inflation pressures that many other global economies are now battling. From a producer perspective, China's PPI measure has accelerated its decline recently, falling from 13.5% in October 2021 – its peak value – to 6.45 in May. Compared to the Eurozone, the US and the UK, the relatively contained level of inflation in China should allow the central government to remain more accommodative (contrary to their counterparts now being forced to tighten conditions as they wrestle to bring down inflation rates now running at multi-decade highs).

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

Lower inflation allows China to further support its economy

And indeed (and again as we discussed in our China update back in March), the Chinese authorities and the PBoC have been implementing several policy tools over recent months designed to boost economic activity, such as reducing the Reserve Requirement Ratio (RRR) for small and big banks (cut three times since June 2021, the last time in April 2022). Our economists have also highlighted the recent rise in Chinese credit growth which in May came in well above market expectations with total social financing (TSF) jumping 42.9% YoY (after the notable contraction of -51.0% YoY in April).  Credit impulse, a classic leading indicator for Chinese equities as it tends to be strongly correlated to EPS revisions in Chinese companies, has also improved (now at -0.7% according to our economists’ estimates and they expect it shortly to turn positive for the first time since early 2021 and to continue to expand over the months to come):

Source: Bloomberg Finance L.P; Pictet; as of 22/6/2022.

In the table below we present a crude summary of the main supportive measures that have been announced by the Chinese authorities in recent months in their quest to support the economy (and ensure it has a chance to get close to the official 5.5% annual GDP target):

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

The recent easing of Covid restrictions is already helping

The ongoing deployment of China’s strict zero-Covid policy has weighed significantly on economic activity over recent months (as is illustrated by the relatively depressed Caixin PMI manufacturing gauge which has been below 50 (i.e. in contraction territory) since March 2022). But it has improved over the past month (the gauge up from 46.0 to 48.1). While the risk that such policy (and/or mass testing) could be reimposed at a moments notice is very real, Covid cases have been abating which calls for less restriction in the weeks to come. Also worth noting is how exports rose 16.9% compared to a year ago in May, smashing expectations for a 8.0% rise – again indicating how the easing of Covid restrictions has already proven a tailwind to economic activity supported by foreign trade:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

Signs of relief are becoming apparent across the economic data

Many of the advance indicators have been showing encouraging signs of relief in May, signalling that the economy is steadily gaining traction:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

The CESI economic surprise index for China has troughed following past phases of strict Covid lockdowns, and again could start to inflect higher as restrictions are eased and the measures that are being taken by the government support growth:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

What of the ‘Fed effect’?

It is worth noting that on average, EM equities have fared well during Fed hiking cycles and moreover, the MSCI Emerging Market (EM) index (heavily weighted in Chinese equities) has outperformed its US and European peers thorough the past five (being those dating back to 1986). Indeed, and as presented in the table below, the EM index has posted an average a return of 18.9% over these cycles (including current), while European (+13.3%) and US (+7.1%) markets lag on average (despite some positive performances). If we look at the statistics dating back to1976, the S&P 500’s average performance over the hiking cycles encompassed by this longer period falls slightly to 6.9%, significantly underperforming the global index (which sports an average return of 10.6%).

While only five full hiking cycles have been completed since the MSCI EM index was first launched, it remains interesting to note that it has proven resilient through Fed hiking cycles, and its current performance (-7.1% as we write) remains less disappointing than its counterparts so far in this one:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022.

A dollar decline could also further support Chinese equity market outperformance in the near term

The significant monetary differential between the Federal Reserve and other global central banks  (especially that between the Fed and the ECB) that has emerged over recent months has, exacerbated by the risk-off mood, sent the US dollar index to levels not reached since 2002.

From a historical perspective, a strong dollar has had a negative impact on the relative performance of the MSCI China (that tends to outperform the MSCI World when the dollar depreciates). The chart below illustrates the strong correlation between the dollar index (here in black, inverted scale) and the relative performance of the MSCI China vs MSCI World. Accordingly, any decline in the US dollar from current highs could support Chinese equity outperformance, in our view (and indeed our economists currently expect the dollar to lose in traction against the eurozone (the EUR/USD pair being the most important in the Dollar Index’s weightings), expecting a slight appreciation of the single currency over next three months to 1.06, then 1.11 in 6 months and 1.15 in 12 months, on the back of ECB rate hikes and supportive fiscal policies on the medium term).

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

The technical outlook also supports the view that the dollar index could lose in traction in the weeks to come

Since it formed a double bottom in 2021, the dollar index has been seeing a significant rally and recently rose above 2016’s high just shy of 104. It lost traction recently, pulling back towards its 50-day SMA, before rebounding and breaking its prior high. However, the RSI is still forming a bearish divergence (suggesting that another pause may occur). The 50-day SMA is acting as a support and a break below it could trigger further decline:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

Market breadth in the MSCI China index is encouraging

As illustrated below,  the MSCI China’s recent outperformance has featured a rise in the number of stocks trading above their 50-day SMAs, to levels not seen since mid 2020. The S&P 500 on the other hand has been suffering extremely weak breadth (with less than 2% of stocks in the US index currently trading above their 50-day SMAs) resulting in extreme breadth divergence.  If we look at the 200-day SMA, the Chinese index has been seeing breadth steadily and continuously improve over recent weeks – in a sign of broad-based support from across the market (while the S&P 500 breadth indicator remains depressed):

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022

Chinese equities are also looking “cheap”

As shown on the graph below, Chinese equities still also appear to be attractively valued as the MSCI China Next-Twelve-month price-to-earnings ratio is currently evolving below its long-term average (11.2x vs 11.8x) while the index remains relatively attractive compared to the global equities (MSCI China’s NTM PE at 0.71x MSCI World’s NTM PE), a discount of 29%:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022

The regulators have recently backed off (albeit potentially only temporarily) 

The regulatory clampdown efforts that the Chinese authorities launched within the framework of their “common prosperity” plan seem to have eased over recent weeks, while concerns around the threat of delisting of ‘non-compliant’ ADRs from US exchanges have for the time being disappeared from financial headlines (and as we discussed back in March, many Chinese officials have publicly announced supporting overseas listings, particularly in the US, a rhetoric that tallies with comments from China’s State Council around its pledge to ensure the stability of financial markets). Such risk has weighed heavy on Chinese internet stocks this past year with the big Chinese internet names seeing blended forward earnings fall from 32.5% on average between October 2020 and now in a move so significant that it suggests most of this risk is now priced – to the extent that the risk-reward on Chinese internet companies might now be considered attractive.

So are we seeing a window of short-term opportunity in which to play some relief in China?

While the global economic and financial backdrop remains challenging with central banks tightening and rising recession risk in many global economies rising, after such a stark selloff it nonetheless remains our view that a tactical rebound could occur on in global equities over the short term.  Moreover, Chinese equities are now increasingly looking more “re-investable” against a backdrop that features strong support from the Chinese authorities that are taking assertive action to mitigate the depressive effects on Covid-lockdowns on growth. Cases have been falling over recent weeks while the authorities remain in support-mode and glimmers of green across the macroeconomic data are beginning to reflect the reopening momentum that has been gaining traction over the past month: in terms of timing there could be more room for Chinese equities to rebound as this becomes more evident.

Longer term however, key risks continue to lie in a return to lockdowns (zero-Covid / mass testing remains policy); property sector malaise / regulation and threat of ADR delisting (should the US start to turn the screws on foreign corporate disclosure / reporting once again).

The technical view

From a technical perspective the MSCI China is enjoying positive momentum and has as we have discussed above been outperforming global peers. The chart below illustrates how the ratio between MSCI China and MSCI world has recently cleared an important zone of resistance at around 63, a level where the upper higher band of the downtrend channel dating back to May 2021 and the horizontal resistance defined by the prior low reached in January meet. This positive price action should pave the way towards the next technical hurdle holding at around 77:

Source: FactSet; Pictet Trading Strategy; as of 22/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

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