China in the crosswinds

05 February 2022

With a reported 8.1% increase in real GDP in 2021, China’s economic growth is the envy of almost all developed countries. But this figure is not all that it seems. Activity slowed markedly late in the year, resulting in growth of just 4%; excluding the period of the pandemic, this was the smallest gain for some decades. Does this matter? Yes and no. On closer examination, the final months of 2021 were pretty much in line with the country’s long-term growth trend, meaning a gradual deceleration since the start of the 2010s that reflects inevitable convergence with growth rates in other major economies. But then the problem of a structural decline in the potential growth rate should not be confused with several short-term risks, which although more cyclical in nature are not to be underestimated: burgeoning private sector debt (the woes of the property sector are a perfect illustration of what this can mean), widespread social unrest and the brutal reassertion of political control over economic life.

China’s private sector debt bubble is the main cause of global economic uncertainty at the moment, as any collapse could the country’s material progress and kick off a domino effect worldwide. The figures certainly make for sobering reading. Official data show that Chinese corporate debt amounted to 139.1% of GDP in 2020, and given the opacity of the national financial system it seems likely that the real number is rather higher.

2022 will see a decoupling of Western from Chinese monetary policies. China has no need to tackle inflation, unlike the USA and euro zone (although strong price pressures in the American economy are still not our baseline scenario). It will therefore favour lower interest rates to bolster domestic activity, which is the precise opposite of what the Federal Reserve wants to do.

Given China’s structural challenges, we will continue to favour Western assets this year. Asian equities underperformed badly last year, correcting 35% between February and year-end; although that should be less marked in 2022 – a number of negative factors have already been priced in – poor visibility on Chinese markets leaves their risk-return profiles less attractive than they are in the West.

Although earnings growth prospects for Q4 2021 were considerably weaker than in preceding quarters, the results season that started in mid-January has been impressive. With a little more than a third of S&P 500 companies having announced their figures at the time of writing, index EPS is expected to be 24.3% for the quarter, compared with an estimate of 21.4% at the end of December. Moreover, 78% of the companies that have reported their results came with positive surprises, just ahead of the average for the past five years (76%). On the other hand, the consensus aggregate estimate is being beaten by ‘only’ 4% at the moment, compared with an average 8.6% (!) over the past five years. In short, the rate at which earnings figures are being adjusted reveals less optimism than has been evident for many quarters.

Our valuation model suggests that US equities are now slightly undervalued, and a 7-8% rise is conceivable under both of our two scenarios. In our view, Wall Street could recover its previous highs but are unlikely to stage a sustained rally. They are more likely to trade sideways, offering scope for stock-picking strategies capable of generating alpha. In the euro zone, our model indicates that equities are undervalued, and just how much depends on where interest rates go (in the event of a slow recovery, they would inevitably tend towards zero). Appreciation potential is slightly greater than that for US equities, at around 12-15% in all our scenarios. We therefore continue to overweight European markets against Wall Street.

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