China in 2022 - Uncorrelated but far from broken

Santiago Millán, CFA, Macro Strategist
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I believe the near- to medium-term outlook for China is improving. As the impact of last year’s regulatory shocks (though not enforcement of said regulations) begins to fade this year, we are seeing some loosening of Chinese policy and signs of an economic bottoming that should be followed by a gradual rebound as 2022 progresses.

I expect the recovery to remain unbalanced, however, with the manufacturing and goods sectors continuing to outpace domestic private services consumption and with investment spending driving much of the economic activity. Meanwhile, the persistence and the unpredictability of the COVID-19 pandemic still pose a risk to the economy, particularly given China’s tough “zero tolerance for COVID” stance.

Whatever transpires later this year, though, I firmly believe China’s economy and its asset prices are not “broken,” but rather are becoming largely uncorrelated — even negatively correlated, in some instances — with other emerging markets (EMs) and the rest of the world (Figure 1). Case in point: As of this writing, Chinese equities were trading at or near historic discounts to many of their developed market cousins.

This trend of declining correlations has potentially important implications for investors in Chinese equities and other assets. I’ll explore that investment aspect in a future blog post, but for now, let me briefly explain what I think is behind the trend itself.

Figure 1

Why China has become uncorrelated

For most of the post-2008 global financial crisis period, China’s economy was closely correlated with other EMs and even with developed market economies. Those correlations began to fall around the middle of the last decade and then virtually collapsed when the pandemic arrived on the scene in early 2020. China’s economy more or less cratered in January of that year, while many other global economies were still pretty much running on full steam. By the time the rest of the world “caught” COVID in March and started to suffer the economic consequences, China’s economy was already beginning to open up and bounce back, outperforming many of its global counterparts in the second half of 2020.

China’s economic fortunes reversed yet again in mid-2021 as the country experienced a regulatory onslaught, while Chinese policymakers took what they saw as a political and economic window of opportunity to focus on sustainability. What resulted was sharp underperformance of Chinese markets in 2021 (the opposite of what occurred in 2020). As 2022 unfolds, I believe China might once again “surprise” — this time to the upside — as an uncorrelated economy and source of investment returns. If my guess is right, its economy should enter an up-cycle at roughly the time that tightening policy and other headwinds (including lofty asset valuations) might leave the rest of the world vulnerable.

How investors can seek to capitalize

Thanks to a massive and increasingly less correlated market, I believe China equity may offer unique and attractive opportunities for discerning investors to pursue alpha generation. In my next blog post, I will highlight some of these opportunities when I lay out my latest thematic investment framework for China.

Authored by
Santiago Millán, CFA
Macro Strategist
Hong Kong