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Markets were surprised to find that a major property developer in China, Country Garden, missed a relatively small interest and principal payment on its debt. This has caused investors to become even more negative about the Chinese property sector, where demand has fallen sharply, and about the Chinese economy in general. Although the Chinese central bank has reduced interest rates, they haven't been cut as much as the market expected given deflationary trends.

Our Emerging Markets teams share their views about what may be at the heart of China's current economic turmoil.

A: At the heart of China's economic turmoil lies an escalating real estate crisis. With over 3,000 developments and a vast land bank primarily located in China's most overbuilt Tier 3 and Tier 4 cities, the company's struggles have heightened concerns of systemic contagion. Subsequently, the highly indebted China Evergrande, which has been an issue since 2021, filed for bankruptcy in the United States, further dampening investor sentiment toward the Chinese property sector and the overall economy. Again, although the People's Bank of China has reduced interest rates, the cuts have not been as extensive as anticipated considering deflationary trends.

Add to this a drop in consumer confidence. Following an initial COVID-19 reopening boom in the first quarter of 2023, China's PMI and exports have experienced a sharp decline. China had hoped to compensate for this downturn with a surge in domestic demand. Contrary to expectations, however, Chinese consumers have exhibited significant restraint in their spending habits. Recent months have seen tepid growth in retail sales while household savings have risen, indicating a growing lack of confidence in the future.

A: By some estimates, real estate accounts for one quarter to one third of economic growth and it represents up to 70% of household wealth in China. While real estate may be the single most important piece of China's economy, its economic issues have stretched far and wide beyond the property market. Over the last few years, China's current administration has boldly pursued the concept of "common prosperity," demonstrating a willingness to disrupt national champions in its quest for greater income equality. This has led to significant shifts in sectors such as e-commerce, online education, and rideshare-hailing, as corporations have been compelled to prioritize state control over rapid revenue and profit growth.

Concurrently, the West has responded to the growing prominence of technology as a national security concern by actively isolating its markets from Chinese tech products. Furthermore, China's strategic alliance with Russia during the Ukraine conflict has exacerbated tensions with Western nations, triggering a sharp decline in foreign direct investment. In combination, these domestic and external factors have not only hindered the growth trajectory of China's tech sector but also propelled businesses to adapt and realign with the government's objectives.

A: In our view, China has not yet implemented adequate measures to stimulate domestic consumption and direct investments toward growth industries. Although we do not anticipate a substantial impact on the overall economic growth rates for 2023, contrary to popular belief, the lack of effective policies poses a potential threat of spiraling debt and deflation if a recovery is not ignited by 2024. IMF projections show China growing at 5.2% for 2023, a target we believe it can meet.

With declining exports and cooling consumer spending, the nation's economic outlook hinges on a potential turnaround. Chinese authorities have signaled a significant easing of previously restrictive conditions aimed at curbing property speculation, but the public has yet to respond with increased spending. China has opted for minor adjustments, such as lowering interest rates and increasing market liquidity, which have failed to bolster consumer or business sentiment.

A: Although we do not consider China "un-investable," as some suggested during the peak of regulatory crackdowns, we believe the capital exodus from China and the worsening economic landscape raises concerns. In our view, identifying the most attractive opportunities in China requires an active approach that targets specific companies with a specific set of characteristics, including high and sustainable levels of financial productivity.

Factoring political risk into investment decisions will likely also be critical in the months and years ahead, given the scale of uncertainties—including the potential consequences of Common Prosperity, worsening real estate crisis, and the ongoing risk of military conflict—hovering over the market.

A: Broadly speaking, Chinese companies, proxied by the MSCI China Index, are near some of their cheapest valuations ever. When looking at valuations over the last 5-7 years, Chinese equities are more than one standard deviation off the mean. From an investment perspective, many sectors and companies in China are significantly more attractive now than in the past (Exhibit 1).

Exhibit 1: Attractive Valuations Offer a Compelling Incentive

Chart shows that attractive valuations offer a competing incentive

As of 23 August 2023
Source: FactSet, MSCI

We believe the key to finding opportunities is to identify companies that are on the right side of regulatory reform and to carefully evaluate their financial health using the same metrics we would use in any other market. This does not mean targeting entire industries, nor does it mean avoiding large companies and focusing on smaller ones. Instead, it means focusing on specific measures of financial health: high and sustainable levels of financial productivity. We are guided by our fundamentally based processes.

A: Given that Guangdong is the richest local government, with capacity to offer a lifeline, we are surprised to see that it has not yet stepped in. On the other hand, the team's view is that the government is incentivized to prevent Country Garden from filing for bankruptcy in China, as it may create more systematic risk than Evergrande.

 

Despite the 30-day grace period, it should be noted that companies that resort to this seldom fully recover, and the damage may have already been done for Country Garden. Other property developers that have used the grace period include Agile and China SCE, where sales dropped 50% year over year due to the decline in demand and lack of buyer confidence. Further, in bankruptcy cases among other developers, the government was not able to find another party to complete housing projects using escrow cash. In this case, 7-8% of total outstanding stock is to be delivered nationwide. There is the potential for protest among home buyers who bought these units over two years ago but are still unable to move in, while seeing the secondary value drop by double digits.

 

Regarding reunification with Taiwan, China's preference would probably be an outcome of "peaceful unification" that avoids a violent invasion with the devastating consequences, not just to the semiconductor supply chains but also to global economic growth. Though unification is unpopular and politically unviable in Taiwan, Beijing seems to believe that if it keeps growing its economic, military, and diplomatic advantages, it will be able to persuade, pressure, and/or coerce Taiwan into a negotiated unification then in the longer term. In the event of a reunification by military force, Taiwanese supply chains would be disrupted, and China would likely be subject to severe, coordinated Western sanctions with perhaps some kind of US-led military response.

A: In the context of emerging markets investing, we believe China is too large a market to ignore. It is home to the world's largest population of over 1.4 billion, and to the world's fastest-growing middle class. Chinese companies constitute nearly 30% (Exhibit 2) of the benchmark MSCI Emerging Markets (EM) Index, so it is understandable that China's stringent regulatory actions, decelerating economic activity, and escalating geopolitical tensions have negatively impacted the index's returns.

Exhibit 2: Chinese Companies Constitute Nearly a Third of Index

MSCI EM Index By Country

Chart Shows How Chinese Companies Constitute Nearly a Third of Index

As of 23 August 2023
Source: FactSet, MSCI

Against this backdrop, we believe investors should proceed with caution and avoid extremes. Following a mass exodus from China due to perceived political risk—as many investors sought to do in 2021 and 2022—may not be practical given the country's size, economic growth potential, market cap weight in the MSCI EM Index, and number of constituents in the emerging markets universe. At more than 30%, it still represents the lion's share of the index, even if that share has gone down.

A: We believe investors should keep a close eye on the actions taken by government officials and businesses, which could affect confidence levels. What is really scaring people is whether inaction by the government is going to really cause property to plummet and, by extension, drag down consumer confidence and the macroeconomic situation. The ongoing housing downcycle has significantly influenced the Chinese economy, given that real estate accounts for approximately one-quarter of China's GDP. Moving forward, global investors will be closely watching housing data and any shift in policy to evaluate domestic consumption and industrial activity.

Published on 29 August 2023.

Information and opinions presented have been obtained or derived from sources believed by Lazard Asset Management LLC or its affiliates (“Lazard”) to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change.

The MSCI China Index is constructed based on the integrated China equity universe included in the MSCI Emerging Markets Index, providing a standardized definition of the China equity opportunity set. The index aims to represent the performance of large- and mid-cap segments with H shares, B shares, red chips, P chips and foreign listings (e.g., ADRs) of Chinese stocks. The index is unmanaged and has no fees. One cannot invest directly in an index.

The MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of emerging markets country indices including: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.

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