Sahil Mahtani | Macroscope: Opportunity knocks when investors lose faith

An investor recently recalled asking an older colleague in late 2000 when the right time would be to buy the NASDAQ. His answer, which turned out to be broadly correct: "When people stop asking that question."

For Chinese equities, that point was reached last year. Faced with rising regulatory and geopolitical risks in an economy shackled by pandemic policy, investors had stopped asking the question. However, then came a pivot on pandemic and macroeconomic policy, and a rally ensued. According to the Bank of America fund manager survey, fund managers went from exceptionally bearish to exceptionally bullish in the span of about twelve months.

Peak optimism was early 2023. Weaker than expected Chinese data in the context of medium-term structural challenges mean investors are again worrying about allocations to China. Year to date the ACWI has outperformed Chinese equities by 15%. Pessimism is prowling in.

We think this is creating opportunities to invest in what we expect will be a robust cyclical recovery.

First, foregrounding structural economic concerns has been a classic error made by investors at the early stages of a cyclical recovery in China. Investors were similarly pessimistic in mid-2012, mid-2016, and mid-2019, worrying about debts, or the property cycle, or about demographics. However, that did not stop Chinese equities from staging a powerful rally from 2016 to 2017. Last year China's real output was 1.5x the size it was in 2016. None of this is to say China's structural challenges aren't real; investors need to think about those long-term challenges. But in the short term what will matter for markets is the course of the cyclical recovery.

Second, China's stalling recovery is easily explainable. The slowdown in the growth momentum in April and May is because policy support was prematurely withdrawn, as indicated in new credit and issuance data. This is not because policymakers are insufficiently committed to easing but because they were probably overconfident about the strength of the recovery on one hand, and worried about the risks of a debt build up on the other. However, with the economy exhibiting plenty of spare capacity--as evidenced by low inflation and high youth unemployment--policymakers have an incentive to pursue expansionary fiscal policy. The top priority, made clear in speeches and minutes since December, remains boosting demand. New policy supports, including one last week on real estate, are being announced. Ultimately, China is a command economy and will go where policy makers want it to, with a lag. The Chinese leadership itself is highly incentivised to deliver a positive outcome given the CCP's social contract with the population.  

Finally, what about geopolitics? Doesn't this make China fundamentally uninvestable? While every asset owner has to make the investability decision in the way that fits the needs of their stakeholders, we believe the spate of geopolitical concerns about China after the invasion of Ukraine is vulnerable to recency bias and availability bias. We would be wary of drawing easy parallels between Russia and China. There are many differences, but two can be cited here: Chinese behaviour in revising the international order has been about mostly working through existing institutions or creating new institutions it can control (like AIIB). Russia has pursued armed combat overseas several times since 2000 (Georgia, Syria, Ukraine). China is a rising power with time on its side. Russia is a declining power. Finally, the barriers to decoupling are much higher. China's economy is deeply integrated into Western production processes, whereas Russia was a relatively small and undiversified economy.

Regardless, the key question for the next 12 months is whether the US-China relationship is getting worse or better: at least three high-level US-China meetings in May 2023 suggest the possibility that things are improving. 

Philosophically, as investors what we are trying to do is invest in assets with macro tailwinds and invest against those with macro headwinds, and crucially to allocate to those ideas countercyclically. Markets over index to short-term noise and focus on past data. We try to do the opposite. Nowhere are the opportunities greater to do this today than in China.