Macro & Markets Guide: China

Country Overview

China, the world's second-biggest economy (and fast closing in on the top spot), is a fascinating fusion of free market and government control. Its economic evolution, starting with sweeping reforms in 1978, has seen it transform from a predominantly agrarian society to a manufacturing powerhouse, with massive urbanization and infrastructure investments.

And the country’s strategic economic diversification has been essential to its growth. Now moving beyond its industrial roots, China has been drawing strength from an expanding consumer market, a commanding services sector, and robust domestic and foreign investments. And that’s allowed it to shrink its reliance on exports and cultivate a more resilient, consumer-driven economy. Moreover, China is making significant strides in technological innovation, with global powerhouses like Alibaba, Tencent, and Huawei helping to shape the global tech scene.

Despite this impressive trajectory, challenges remain. China faces internal hurdles like an aging population, high debt loads, and environmental woes. On the global stage, tensions with countries like the US can rattle its supply chains and international trade. Nevertheless, China, with its diversified business ecosystem, its knack for tech innovation, and its very hands-on government, hopes to continue to reshape the global economic landscape.

Economic Update

The economy has hit a speed bump, but not a dead end.

China was tipped to roar back post-Covid, but its economy grew by just 0.8% in the second quarter of 2023 versus the first quarter – not exactly a sizzling pace, even if the economy was a hefty 6.3% bigger than in the same time last year. Economists and investors were hoping for a bit more spark.

China's having a hard time because of four main issues. First, the global demand for its exports is drying up, as high interest rates and a post-Covid consumer preference for services crunched the demand for goods. Second, Chinese consumers are tightening their belts, after a drop in home prices and a surge in youth unemployment. Third, its gargantuan property market is languishing, thanks to the combination of high interest rates and debt levels. And, fourth, businesses are cutting back, hesitant to invest amid regulatory crackdowns and rising tensions with the US.

But don't count China out. Despite the tough times, economists are still predicting annual growth of over 5% for the rest of the year. Leading indicators also show signs that a rebound could be on the horizon. And let's not forget who's running the show. With a government that has its hands firmly on the economy's levers, China has the power to pump up the volume if it chooses to, potentially igniting a major comeback with a chunky stimulus package.

The economy has hit a speed bump, but not a dead end.

China’s inflation is swimming against the global current.

China's walking its own path in the global inflation woods, with a headline inflation rate at a big fat zero. When the rest of the world felt the sting of rocketing energy and food costs after Russia's invasion of Ukraine, China's strategic price controls and sturdy supply chains kept things steady. And China’s Covid stimulus packages didn't have the oomph of the ones approved in the US, so they created far less upward pressure on prices. Plus, China's strict Covid control measures hit consumer and private investment hard: their echoes remain, with confidence still wobbly, long after the measures were eased.

Investors and economists are predicting only a tiny uptick in China’s inflation, expecting it to just touch 1% by year’s end and crawl past 2% early next year. And, drawing a stark contrast to most countries, investors are actually lowering their inflation predictions, because of the weaker-than-expected economy. In fact, the real bogeyman for China isn't inflation, but its nasty cousin, deflation. If prices start a downward spiral, corporate profits could take a hit and debts could become heavier – a tricky situation the Chinese economy doesn’t want to be in.

China’s inflation is swimming against the global current.

The central bank’s been lowering interest rates and it could take even bigger measures.

While the rest of the world has been hiking interest rates faster than you can say "inflation," China's central bank has been cruising in the opposite direction. Thanks to the country’s low inflation, Chinese policymakers have the luxury to keep rates lower than their peers. In fact, instead of tightening the purse strings, they’ve been loosening things, with measures designed to boost growth and manage debt. But don't get too excited – they’re not breaking out the stimulus "bazooka" that investors might be hoping for, the kind used during the global financial crisis. It seems the central bank is opting for a more measured approach this time around.

Thanks to the country’s low inflation, Chinese policymakers have the luxury to keep rates lower than their peers.

Stock Market Overview

China's robust financial market boasts three major stock exchanges, each serving distinct roles in the country's bustling economy. The Shanghai Stock Exchange, nestled in China's financial epicenter, ranks as one of the world's biggest exchanges by market capitalization and is the go-to destination for some of the country's corporate heavyweights. A hop, skip, and a jump away, there’s the Shenzhen Stock Exchange, a buzzing hive for tech-oriented and growth-centric firms. Completing the trio is the Hong Kong Stock Exchange, which not only connects international investors to Chinese companies, but also provides a platform for businesses from around the world to list and trade.

The main exchange-traded fund (ETF) is the iShares MSCI China ETF (ticker: MCHI; expense ratio: 0.58%). Think of it as your one-stop shop to invest in a mix of big and mid-sized Chinese firms. It follows the MSCI China Index – a collection of these firms with different kinds of shares around the globe. You've got H shares (China-based firms listed in Hong Kong) and B shares (the same sort of firms but listed in Shanghai or Shenzhen, and typically bought with foreign cash). The mix even includes shares of Chinese companies listed in the US, known as American Depositary Receipts (ADRs). Most of these shares are bought and sold on exchanges in Hong Kong or New York. So with MCHI, you're diving into a diverse pool of Chinese firms listed around the world.

The MCHI ETF is like a bag full of consumer-focused, communications, and finance companies. This makes it heavier on these sectors than a broad US index like the S&P 500, and a bit light on tech and healthcare. But don't be fooled: its tech understatement is more of a label issue. You see, giants like Tencent, Alibaba, and Baidu are technically classified under "communication services," but they're as tech as they come. So, in reality, the ETF isn't just dipping its toes into the world of rapidly growing tech firms; it’s diving in headfirst.

The ETF’s top ten holdings include internet heavyweights Tencent, Alibaba, Baidu, Meituan, and Netease, consumer discretionaries JD.com and PDD, automaker BYD, and financial services China Construction Bank and insurer Ping An.

With the top 10 stocks representing only 40% of the index, the ETF is quite diversified.

The MCHI ETF is like a bag full of consumer-focused, communications, finance, and tech companies.

Chinese shares are relatively cheap and high-yielding.

Chinese stocks are cheaper and higher-yielding than their US counterparts: they’re serving up a dividend yield of 3.3%, and benefit from relatively attractive valuations with a price-to-earnings (P/E) of 12.6 and price-to-book (P/B) of 1.3. They are, however, less profitable, with a return on common equity of only 9% – almost half that of US stocks.

But while Chinese stocks may seem like a steal at the moment, there's a catch. Investors are playing hard to get, concerned that an escalating geopolitical tango between China and the US might turn these stocks into financial hot potatoes. And let's not forget the other elephant in the room: heavy government involvement in the Chinese markets has investors demanding a discount for taking on that extra risk.

Chinese shares are relatively cheap and high-yielding.

Chinese stocks have resumed their underperformance this year.

China’s economy has been growing fast in recent years, but its stocks haven't been setting the world on fire. Sure, they fared better than US shares last year, but now they're stuck in the slow lane. And it's not just economic sluggishness putting the brakes on; investors are also keeping an eye out for geopolitical speed bumps. So, look, there’s no sugarcoating it: Chinese stocks are facing some risks in the short term. But if you’ve got a long enough horizon, they may be an interesting addition to your portfolio.

Chinese stocks have resumed their underperformance this year.