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April 20, 2023 | 15 Minute Read
Head of Private Equity in Asia and Global Co-Head of Growth Equity
Head of Asian Fixed Income and Co-Lead for Emerging Corporate Debt
Co-Head of China Equity
China has reopened. The recovery of the world’s second-largest economy is underway after three years of some of the strictest public health measures globally. An earlier and faster-than-expected departure from zero-COVID policy began at the end of 2022 as major cities abolished mandatory mass testing requirements. Rules around domestic quarantine requirements and inbound travelers eased in January as China welcomed the Year of the Rabbit with Lunar New Year holiday celebrations. The reopening has occurred in tandem with a strong policy shift towards supporting growth by facilitating a consumption recovery and rebuilding consumer confidence, including measures to stabilize China’s property sector. This policy pivot led to a cyclical recovery between November 2022 and February 2023 as sentiment toward Chinese assets improved and fueled one of the best performing three-month periods on record for the MSCI China Index—albeit from a depressed starting point. A nine-day long policy event, the National People’s Congress (NPC), concluded on March 15 with policymakers re-emphasizing stability of growth as a key goal of the government and reassuring the private sector and international business community of Beijing's pro-business stance. As many aspects of China’s economy and society normalize over the coming quarters, we expect China’s growth momentum to improve. While a cyclical recovery may continue to drive markets in the near term, successfully navigating China’s next chapter will also require public and private investors to refocus on a wide set of new opportunities—and new risks. These include long-term secular tailwinds and structural headwinds with the potential to affect asset class performance and investment portfolios in the years ahead.
The potential pace and magnitude of a consumption rebound in China this year remains firmly in focus among market participants. Chinese household consumption was ~7% below potential in 2022, implying significant room for recovery.1 If the post-pandemic consumption pattern of other economies leaves any indication, China may see sharp rebounds in discretionary consumer goods and services spending, especially domestic tourism. During China’s Lunar New Year Golden Week (January 21-27), movie box office revenues, postal package delivery, and restaurant sales all exceeded 2019 levels. There was also a V-shaped recovery of domestic air traffic and booming hotel demand. Consistent with the mobility data, China has returned to work with a sense of urgency. Purchasing Managers’ Index (PMI) data came in above consensus expectations in February, with the Caixin Services PMI—the most sensitive part of the economy to a reopening—surging to 55.0 well above the historical mean of 53.7.2 We believe China’s reopening has the potential to trigger a consumption revival in 2023 led by a release of pent-up demand, improvement in the labor market and incomes, and a broader recovery in consumer confidence. However, it is still too early to tell how robust and durable China’s economy will be, and three years of zero-COVID policy and eighteen months of property sector stress have left scars that could hinder a broad-based consumption recovery. For example, elevated unemployment rates among China’s 16-24-year-olds could weigh on the consumption capability of this cohort, even as the recent relaxation in various regulated areas, such as tech and education as well as the more recent recognition of platform companies as national champions and employment generators, provides some support for job prospects and income security. Meanwhile, cumulatively, from 2020 to 2022, excess savings in China—which we define as the amount of savings above what a “normal” pre-COVID savings rate would imply—appear to be relatively small in contrast to other economies such as the US, estimated at less than 3% of GDP or 6% of household disposable income at the peak during the pandemic, though in absolute terms this number exceeds RMB 3tn (~$435bn).3
Source: (Top) NBS, Goldman Sachs Global Investment Research. As of December 31, 2022. (Bottom) People’s Bank of China (PBoC), Haver Analytics, Goldman Sachs Global Investment Research. As of December 31, 2022.
Along with signs of a consumption rebound, we believe it will be vital for investors to closely monitor global spillover effects from China’s reopening on goods trade, international travel, and commodities. Increased domestic demand in China could boost goods exports from other economies, for example. We expect Asian economies—which account for more than 50% of China’s import demand—to be the key beneficiaries of this growth impulse, though results will vary at a country level. China is the largest export market for most economies in the region, absorbing 50% of exports from Taiwan and Australia, 30-40% from New Zealand, Korea, Malaysia, and the Philippines, and around 20% from the rest (with a notably smaller 7% for India). The distribution of benefits will also depend on which sectors in China experience the strongest growth. Taiwan accounts for a quarter of tech imports into mainland China, for example. Demand recovery in foreign services, particularly for international travel, would additionally provide a modest boost to global activity. Again, Asian economies and some developed markets are likely to benefit if international travel returns to pre-pandemic levels. Higher commodity demand and prices are another channel through which China’s reopening will affect other economies. China is the world’s largest commodity consumer and biggest oil importer, and we expect its reopening to be moderately inflationary due to higher commodity prices. Within China, the unique nature of the post-reopening recovery may result in a mixed inflation picture. Prices of pork, a staple in China, surged in 2022 but may be less of an issue as supply disruptions begin to ease. Durable goods such as autos, smartphones, and computers tend to have long and sophisticated supply chains and are likely to be affected differently by reopening.
China’s reopening and recovery will be closely watched by many investors over the coming quarters. Data suggests hedge funds moved swiftly to rebuild China exposure from November to January. Active mutual funds globally re-risked to a lesser extent. However, by the end of February, Chinese equity funds had recorded steady year-to-date inflows of ~$3.6bn from global mutual fund investors.4 We see large pools of capital that do not have the level of holdings in China that they used to allocate. This implies that net foreign buying may continue in the months ahead, especially given the recent improvement in China’s fundamental outlook. Revenue normalization in areas that have been impacted the most by COVID restrictions may remain a tailwind and could drive further equity gains. The downside risk of maintaining underweight exposure to Chinese assets could therefore be high. We see public market strategies well placed to capture further upside in the near term. These strategies can take advantage of both improving fundamentals and tactical re-rating opportunities in areas where valuations are still suppressed relative to historical ranges, notwithstanding the recent rally. We expect China’s equity and fixed income complex to contain an abundance of alpha generating opportunities for bottom-up, active managers in 2023 and beyond. Many investors still include China as part of a broader allocation to Asia or emerging markets; however, China’s size and the breadth of its equity and fixed income markets could merit a standalone country or incremental regional allocation for investors considering Chinese equity and fixed income exposure. Both China’s A-share market and Chinese fixed income markets boast a strategic investment case for international investors underpinned by their size, liquidity, and diversification appeal.
Despite optimism around China’s reopening and recovery in the near term, we expect headwinds to shape China’s growth trajectory and asset class performance in the years ahead. We examine three key issues in more detail: property sector stress, demographic shifts, and geopolitics.
First, China’s property market remains a key concern. The country’s real estate market stayed soft in 2022 amid continued liquidity and credit stress for developers, even as greater concerns over contagion risks stemming from Evergrande’s default began to abate. More recently, sentiment has further improved as policymakers’ tone towards the sector has turned decisively more dovish. Credit support to both high-quality developers and homeowners has been introduced and we expect more policy easing to come. We have since seen a recovery in both primary and secondary property transactions year-to-date. The long-term policy focus is likely to be on managing a multi-year property sector slowdown, rather than engineering an upcycle. Property developers’ debt-repayment problems have been among the biggest issues affecting Asia’s credit markets over the past two years. More recently, the asset class has experienced a forceful rebound. A recent rally of China property high yield bonds reflected a reduction of left tail risk for the stronger developers. We think stresses and defaults could continue to build and the near-term outlook remains challenging. Even so, we believe there is a potential opportunity for attractive total returns in the deleveraging of the Chinese property sector through active security selection, while recognizing that Asia’s credit markets represent a diverse opportunity set beyond China.
Second, China’s changing demographics will likely present long-term challenges to the country’s growth potential and alter the structure of its economy. China’s population started shrinking in 2022 for the first time in six decades.5 The demographic transformation has led to an increasingly top-heavy population pyramid. China’s old-age dependency ratio (the ratio of the population aged 65 and over to the population aged between 15 and 64) is expected to increase from 10% in 2000 to 41.5% by 2040, according to United Nations projections.6 Although China loosened its family planning restrictions in 2015 to address emerging demographic problems, birth rates have not improved following the implementation of the two-child policy. Even if China were to further relax its birth policies, fertility rates may not increase due to structural factors, including the fall in the number of women of childbearing age—a result of family planning that began in 1980; and improving living standards and education levels delaying marriages and childbirth, and the pressures and costs of parenting. Demographic headwinds are not unique to China. Many countries have increasingly aging populations, but China is already home to the largest population of older people in the world. Investors have opportunities to lean into areas of demographic change. Segments of China’s healthcare sector stand to benefit as aging consumers start to spend a higher proportion of their budget on medical services and less on tangible goods. At the same time, President Xi Jinping has put health and social care at the center of the government’s policy agenda. More broadly, lower labor force participation rates tend to raise labor costs and result in retirees drawing down savings. This may constrain the available supply of capital, potentially creating compelling opportunities for private investors seeking to put capital to work in China.
Source: Goldman Sachs Global Investment Research, NBS, United Nations World Population Prospects. As of February 10, 2023.
Third, geopolitical risk remains a significant overhang on Chinese assets. The Russia-Ukraine war raised investor concerns around geopolitical issues, including China-Taiwan tensions and US-China trade and technology frictions. Diplomatic tensions with the US increased at the start of 2023 as the US shot down a suspected surveillance balloon and Secretary of State Blinken postponed his planned trip to Beijing. Strained relations between the US and China appear to have encouraged both to strive for more self-sufficiency in key industries. This may lead to more centralized economic policies where state intervention plays an important role, either directly or indirectly, through incentives and disincentives to decision makers and businesses. The US move to ban the transfer of advanced semiconductor technology to China may prompt Chinese leaders to ramp up state-directed investment in domestic chip producers and bolster onshore manufacturing. This could intensify the race between the two countries for dominance in the tech sector. Elsewhere, Beijing and Washington have also been at odds over access to audit papers of Chinese companies. Since 2021, Chinese offshore initial public offerings (IPOs) in the US have almost ground to a halt. However, February saw the first Chinese company to raise more than $100 million in the US in 15 months as China’s securities regulator eased curbs on overseas IPOs, sparking hopes that Chinese companies will restart their ambitions to list in major markets such as New York.
Geopolitical headwinds and new alliances ultimately create a more uncertain environment that weighs on consumer and corporate confidence. Governments’ fiscal spending priorities may also change, with increased spending on defense and/or more support for domestic industries. Private capital may be advantaged by its ability to provide long-term, patient capital that can respond to long-term shifts, while reacting less to near-term geopolitical gyrations. Private capital can also provide investors with access to a broader selection of industries given the stops and starts in the IPO market. From an FX perspective, global instability is also leading to a desire for greater currency diversification and could give rise to more institutional investor allocations and central bank reserves potentially shifting to RMB and EUR, alongside the dollar. That said, there are still material barriers to a wholesale shift into RMB. For example, foreign ownership of Chinese Government Bonds (CGBs) remains low at around 12%, although we think CGBs continue to offer investors diversification benefits given their low correlation with other assets.7 We also expect structural inflows as a result of increasing weights of CGBs in major bond indices to be supportive for the asset class over the long term.
Every new cycle has new winners, and in China, picking the right themes and sectors in the right cycle has demonstrated to be highly rewarding. As China enters a new chapter, we believe it will be critical for investors to align their portfolios with long-term secular trends. This may include opportunities that are essential building blocks to—or at least well-synced with—initiatives set to guide China’s economic growth orientation in the decades ahead. China’s Common Prosperity vision, for example, is a concept which we believe represents a growth reorientation where policy support could pivot towards industries that carry long-term strategic value to China, including areas of technology, healthcare, and decarbonization.
Prosperity heavily depends on the ability for China to grow its economy in a high-quality, efficient, and sustainable manner. We believe China will have to develop its internal production capabilities in foundational technologies, specialized equipment and essential materials along key supply chains, such as semiconductors and enterprise software, if it is to improve its global competitiveness and self-sufficiency—especially against a backdrop of elevated US-China tensions. Building out digital infrastructure will also be essential to enable China to reach its long-term growth targets. Digitization will touch most areas of China’s economy, but we believe it could have the greatest impact on the enterprise technology and financial sectors.
Core technology aside, energy security is another necessary condition for sustained growth. While China is the largest producer of rare earth elements critical for energy transition, it is also the largest energy consumer in the world, representing 14% of oil and 52% of coal demand globally. About 73% of its oil consumption and 8% of coal is sourced externally, underscoring China's heavy dependence on energy imports in areas that could expose the country to national security concerns.8 The word "ecology" has also received significant mentions in many official Common Prosperity reports, and reducing energy pollution is a core component of sustainable development. We believe China's pledge to reach peak CO2 emissions by 2030 and carbon neutrality by 2060 will continue to underpin its quest for less-polluting energy supplies and enhancing energy efficiency. This could usher in secular investment opportunities centering on renewables (e.g. solar, wind, hydrogen) and environmentally-friendly energy applications, notably electric vehicles and related supply-chain components (e.g. battery technology and charging piles). Policymakers are also increasingly focused on alleviating water scarcity and reducing water pollution.
Source: Company data, Energy & Climate Intelligence Unit, and Goldman Sachs Global Investment Research. As of January 20, 2021. For illustrative purposes only. The economic and market forecasts presented herein are for informational purposes as of the date of this material. There can be no assurances that the forecasts will be achieved. Please see additional disclosures at the end of the material.
We believe finding and executing public and private investments in areas that benefit from structural tailwinds will prove rewarding. The make-up of China’s newly born unicorns—privately held start-ups with valuations over $1 billion—is increasingly concentrated in industries that are more aligned with China’s national development goals. In 2022, 70% came from four fields: clean technology, renewable energy, healthcare and smart logistics.9 Economies of scale and industry consolidation have historically been winning formulas in China. Going forward, a focus from policymakers on regulating anti-monopoly behaviors, discouraging cross-sector capital expansion for platform operators, and offering targeted support to emerging companies may strengthen the competitive positioning of small and medium sized enterprises. ‘Little Giants’—emerging companies handpicked by China’s authorities for explicit policy support—are particularly aligned with strategic policy goals. These small/mid-caps are mostly found in capital goods, new materials, technology hardware and semiconductors. These sectors are critical to Chinese national security, growth sustainability, and the Common Prosperity initiative.
China remains a large, growing market with a vast opportunity set. But as China reopens and its economy recovers, the country’s next chapter is set to look a lot different than the last. This means investors cannot rely on their existing game plan. As the long-term trends in China shift, it is important to see the change, understand the change, and continue to look forward. We believe investors will need to take a more nuanced view of public market exposures and add thoughtful idiosyncratic exposure to private markets with managers able to identify and execute in thematic areas with structural tailwinds. This could make portfolios more resilient as China enters its next chapter.
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1Goldman Sachs Global Investment Research. China post-reopening consumption recovery: Large potential, lingering scars. As of January 18, 2023.
2Goldman Sachs Global Investment Research. As of March 1, 2023.
3Goldman Sachs Global Investment Research. China Data Insights. As of February 7, 2023.
4EPFR, Morningstar, MSCI, FactSet, Goldman Sachs Global Investment Research. As of February 28, 2023. Morningstar data includes flows across China Equity and China A-Share Equity categories. Past performance does not guarantee future results, which may vary.
5National Bureau of Statistics of China. As of January 18, 2023.
6Goldman Sachs Global Investment Research. Population Aging, Pension System, and Individual Retirement Savings in China. As of February 10, 2023.
7Source: IMF, Goldman Sachs Global Investment Research, Goldman Sachs Investment Strategy Group, and Goldman Sachs Asset Management. As of January 29, 2023.
8Goldman Sachs Global Investment Research. Finding the "Common" paths to "Prosperity". As of October 25, 2021.
9South China Morning Post (SCMP). China added 74 unicorns in 2022, maintaining steady pace of growth despite fundraising crunch. As of February 3, 2023.
Alpha refers to returns in excess of the benchmark return.
Bps refers to basis points or 1/100th of 1%
Correlation is a measure of the amount to which two investments vary relative to each other.
Dovish refers to more accommodative monetary policy, the opposite of Hawkish
FX is foreign exchange market.
GDP is Gross Domestic Product
Left-tail risk refers to the risk of unlikely yet extremely negative portfolio outcomes.
PBOC is People’s Bank of China
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Date of First Use: April 20, 2023. 310270-OTU-1771097