Chinese stock markets experienced a volatile 3Q with most indices posted low single digits losses. CSI300 and HSCEI indices down by 4.0% and 4.3% respectively, as sharp downturns in August and September reversed the strong rally gains in July. Our Chongyang Dynamic Value Fund (“the Fund”) posted a XX return of XX% in 3Q.  

It has proven to be a much difficult year for investors in Chinese equity markets. The rosy outlook we had envisaged at the beginning of this year failed to materialize. Our bull case was built on two key predictions: 1) a strong cyclical recovery in the economy underpinned by accommodative macro policy stances and unleashing of pend-up demand in the wake of end of zero-COVID policy; and 2) a significant improvement in global liquidity conditions featuring a combination of peaking US treasury bond yields and softening of DXY. However, both predictions were off the mark by a considerable margin. With the benefit of hindsight, we got wrong calls on the cyclical conditions for both China and U.S., as there was neither a meaningful recovery in the former nor a meaningful recession in the latter.

With the markets unexpectedly down, investors’ confidence is shattered, market sentiment depressed, and narratives of pessimism abounds. In particular, besides the abovementioned cyclical arguments, there are rising concerns that Chinese economy is facing serious challenges from a structural perspective, including high debt, demographic headwinds, and declining real estate prices, all of which combined help justify the poor performance of the stock markets. Some observers even used terms such as “the end of China’s miracle,” “a lost decade,” “Japanification,” and “a balance sheet recession” to describe the China’s current predicament. We beg to disagree, however.

There are indeed some similarities between 1990s Japan and present-day China. But a“balance sheet recession," a term coined by Richard Koo in the late 1990s to describe Japan’s situation after the collapse of the financial bubble formed earlier in the decade, for China seems far-fetched. Specifically, the blow to Japan’s balance sheets at the time was staggering: The Nikkei Stock Index fell from 39,000 at its peak to 13,000 by the end of the decade. Commercial real estate lost 80% of its value, and residential land prices fell by two-thirds between 1991 and 2005. At the time of the collapse, Japan was already an aging society, and the urbanization rate, at some 77% in 1990, had started slowing.

China is in a very different situation today. While the property sector is seriously affected by the current downturn, its decline was manifested in the volume of sales and construction, rather than in actual price changes. The perceived wealth of Chinese households, which hold about two-thirds of their wealth in real estate, has barely been affected. Thus far, these changes represent a modest adjustment, not the major shock Japan experienced in the early 1990s, or even the decline in asset values the United States experienced during the 2008 global financial crisis. Specifically, according to an early study by BOJ, the decline in the combined value of Japanese property and stocks during the country’s recession amounted to about 230% of GDP; in the United States, the decline in asset values after the global financial crisis equaled 100% of GDP. For now, the decline in Chinese property values is far smaller, and losses are mainly contained within the property sector itself. China’s corporate sector as a whole is far less leveraged than Japan’s in the 1980s: The debt-to-equity ratio is currently about 1.25 in China, and has reduced in recent years. In Japan, that ratio was three times higher during the peak of the bubble.

We currently assign a subjective probability of 80% to cyclical factors and 20% to structural ones in explaining the causes for the current economic and market downturns. However, the markets may have discounted these two scenarios with even odds by overplaying the role of structural factors. In particular, we would like to highlight the roles of policy mistakes which hampered the recovery in domestic demand and a deterioration in external environment which contributed to weak exports so far this year. On the policy front, both fiscal and monetary policy stances in China turned out to be contractionary instead of expansionary in 1H, contrary to what the headline policy statements indicated. This is because the policy authorities may have made the same mistakes as many market participants did by expecting a strong autonomous rebound in economic activity once the zero-COVID policy was abolished. We think that the lag effects of de facto policy tightening explained the sudden weakening in growth momentum in 2Q. In this context, the unwinding of the draconian deleveraging policy targeted at the property developers also proved to be too piecemeal to be effective.

Chinese authorities did not make a more decisive pro-growth policy shift until late July when slowdown became so evident. As a result, a wide range of policy measures, including in particular a broad-based relaxation of the various controls on demand for residential property, have since been pushed out in a rush, aiming primarily at boosting domestic demand. As such, the latest high-frequency data started to show signs of stabilizing and even rebound in activities in August and September. We expect the authorities to stay on the course of policy easing until a recovery is firmly on track.

Looking ahead, we maintain a positive outlook for the markets despite having got the top-down calls wrong so far. In a sense, we are back to square one, or a situation similar to where we were around the same time of last year. To be sure, we are not as outright bullish as we were back then, because we realize that the scaring effects of zero- COVID policy and zero-credit (to private property developers) are more lasting than we initially estimated. And the global liquidity conditions will probably not become tailwinds to Chinese markets any time soon, since the Federal Reserve is expected to keep rates “higher for longer.” But we are definitely not bearish at the current juncture, because a recovery appears to have been delayed instead of being completely absent. We will therefore keep close track of implementation of the various reflation policies and emerging green shoots in economic activity. Besides domestic economic fundamentals which hold the key to assessing the market outlook, we also take note of the latest positive developments on the front of US-China relations, which tend to go a long way toward boosting investor confidence. 

The subpar YTD performance of our Fund could be primarily explained by the large drawdown suffered in 2Q, in part reflecting the high risk exposure of our portfolio which in turn was a function of our top-down bullish views. At the same time, our balanced and diversified portfolio in terms of sectors and sub-sectors has, to some extent, helped mitigate the potential loss. Credits go to our multi-PM investment management system which ensures from bottom up a robust alpha-generating portfolio without taking concentrated positions.