China's capital markets: The elephant in the room

China's fast economic expansion and leading position in global commerce have resulted in a quickly expanding financial system with a more broad and accessible capital market. The progressive elimination of capital controls has already increased foreign investment, particularly in portfolio flows in equities and debt instruments. Long-term institutional investors, such as insurance firms, have increased their presence in China as their exposure to high-growth developing market countries has increased, but with low direct exposure in local currency. Foreign investors are primarily interested in three asset types in this context: local currency government debt, highly rated corporates, and stocks. These asset types often account for most insurers' investment portfolios and drive current exposures to China.

Because of robust governmental support, China's economic outlook remains positive. China has suffered minor economic damage and has quickly resumed pre-pandemic activity this year. We estimate the present downturn to end in the second half of next year, with growth remaining strong compared to the US and the Eurozone (+7.9 per cent and +5.2 per cent in 2021 and 2022, respectively. More significant fiscal stimulus at the regional level, supported by the issuing of special bonds, should assist local governments in increasing public investment. Furthermore, borrowing costs should stay low because of the central bank's window guidance and substantial system-wide liquidity. These policy changes and the temporary easing of some laws will likely contribute to a soft landing for the economy.

During the Covid-19 crisis, equities were a significant underperformer in the Chinese stock market. Due to the real estate industry downturn and the regulatory crackdown, equities have been under tremendous pressure, mainly offshore. However, the market downturn has not been followed by a structural worsening in fundamentals, making Chinese shares appear reasonably priced at current levels. Thus, price-to-earnings (P/E) ratios appear low compared to other foreign markets, implying that Chinese stocks were oversold amid worries of more market declines and external market volatility. Furthermore, earnings expectations have not followed the price correction route and continue to point to a good profits recovery in 2022 and 2023, supported by favourable long-term EPS growth estimates.

The central bank's accommodating posture (proxied by the PBOC's balance sheet) appears to explain the majority of equity performance (similar to corporate credit). At the same time, interest and foreign exchange rates have only a minor effect. As a result, the present softer monetary policy should benefit Chinese equities in the future. We predict Chinese onshore shares will prosper despite specific economic challenges, but offshore equities will remain cautious due to stricter restrictions' possible knock-on effects. Given China's relatively high percentage of the global developing market stock index, particularly in the "offshore" section, spillover effects for Chinese equities are more robust than for corporate debt.

Trade shocks, in particular, appear to have a disproportionately negative impact on equities market performance. Negative statements relating to the trade conflict with the US have historically resulted in a 1% drop in the overall market value of Chinese enterprises over two months following each announcement. The prospect of a new trade battle with the US and the possibility of this spreading to trading partners amid slowing Chinese imports from the area might harm confidence, which the financial market reaction would exacerbate.