COVID policies, property woes rain on China's parade

China's zero-COVID-19 policies and property market woes are weighing on consumer sentiment this year, clouding what could otherwise be a rosy outlook for Chinese equities as Beijing works to steady an economy hobbled by last year's broad regulatory reset.

Those land mines have overshadowed the emergence of a friendlier policy backdrop on the mainland this year. Despite those hurdles, some overseas investors have begun adding beaten-down Chinese stocks to their portfolios, betting that the government can eventually come up with a stimulus mix capable of reviving the country's slowing economy.

Iain Cunningham, Ninety One U.K. Ltd.'s London-based co-head of multiasset growth, said Beijing's decision to prioritize stability this year over structural reforms prompted his team to begin adding back stocks they had dumped starting in the second quarter of 2021 in the wake of last year's "enormous regulatory reset" for China's education and internet platform sectors, among others, and the rollout of aggressive macroprudential measures for the housing market.

Over the nine months since the first signs of that regulatory about-face surfaced in December, Ninety One's benchmark-relative strategies have gone overweight China from underweight, Mr. Cunningham said. For the firm's absolute-return global macro strategy, meanwhile, Chinese companies now account for almost two-thirds of a 30% allocation to global equities, double the level of late 2021. Normally, the strategy's allocation to global equities would be between 60% and 80% but with bearish views on developed markets now, Ninety One's team has struggled to keep U.S. and European stocks in the portfolio, he said.

Chinese stocks offering considerable value now over a three- to five-year horizon include Alibaba Group Holding Ltd., until recently perhaps the highest-profile target of local regulators; Ping An Insurance (Group) Company of China Ltd.; Shenzhen-based online brokerage and mutual fund services provider East Money Information Co. Ltd.; and Wuxi Lead Intelligent Equipment Co. Ltd., a Shenzhen-based maker of lithium battery production equipment, Mr. Cunningham said.

Along with compelling valuations, fans of Chinese stocks now are also emphasizing diversification benefits vis-a-vis their U.S. and European counterparts.

Investors shouldn't underestimate the importance of China's ability to stimulate its economy at a time when the U.S. and other developed nations are struggling to put out inflationary fires, said Michael Edwards, deputy chief investment officer with Weiss Multi-Strategy Advisers LLC, a New York-based hedge fund manager with $4.2 billion in assets under management.

In May, one sleeve of the Weiss fund, with a typical investment horizon of one or two months, went from net negative China exposure of 2 percentage points to positive exposure of 10 percentage points, including a "very long" position in tech platforms that had been targets of regulatory scrutiny the year before, such as Alibaba and JD.com, Mr. Edwards said. This year, by contrast, China's State Council "is going out of its way to underscore the importance of tech platforms for Chinese growth," a rhetorical shift that clears the air for investors to get more positive, he said.

Finding himself the lone CIO at a gathering of 20 industry compatriots in May who would admit to considering China investible was ultimately a strong signal that the time was right to become more positive, Mr. Edwards said. A negative consensus on that scale suggested the emergence of any positive news was likely to spark a sharp move to the upside. And shortly thereafter came reports of "some relatively positive, semi-digested Xi Jinping thought on the importance of tech platforms" for China's economy, a sharp departure from the critical tone Beijing had maintained toward those platform stocks over the prior year or so, he said.

Between mid-May and the end of June, Alibaba and JD.com posted respective gains of 31% and 25%, before a new round of COVID-19-related lockdowns found Chinese shares giving back some of those gains.

Elsewhere, Mr. Edwards said his fund is adding China "green tech" stocks in segments such as solar and electric vehicles from more of a strategic than tactical viewpoint. With those stocks available now at attractive entry prices, "we might lighten up at times but for the most part I'd be adding to those positions" over time, he said.

If some investors are nibbling, however, the performance of broad benchmark indexes this year shows Chinese equities continuing to trail the pack among Asia-Pacific markets. The Hang Seng China Enterprises index, which tracks 50 of the largest Chinese companies listed on Hong Kong's Hang Seng index, closed Aug. 19 down 17.94% year to date, better than the 21.22% drop for the S&P/BNY Mellon China ADR index of Chinese companies listed on Wall Street. Shanghai- and Shenzhen-listed A shares have declined 10.49% and 12.73%, respectively.

The Japan Nikkei 225 is up 0.48% year to date; the Indonesia JSX has risen 8.98%; the Singapore Strait Times index is up 3.93%; the India S&P BSE Sensex has increased 3.47%; and the Australia S&P/ASX 200 is down 4.43%. The South Korea KOSPI index is down 16.29%.

"I do see money moving to Hong Kong and China but probably not to the extent to continue to drive the market to perform better than other markets," especially with U.S. stocks rebounding recently, noted Edmond Huang, a Hong Kong-based managing director, head of China and Hong Kong research and China equity strategy with Credit Suisse.

Lingering concerns about COVID-related lockdowns remain an obstacle to a more full-throated embrace by investors of Chinese stocks, he said.

More broadly, Beijing's strict zero-COVID-19 policies, shutting down cities as important as Shanghai to nip outbreaks in the bud, and a property market buckling now under borrowing controls, which have pushed a number of big developers into bankruptcy, are working against the kind of rebound in consumer confidence the government needs to power China's consumption-driven economy.

On the property side, a recent boycott by Chinese homebuyers on further mortgage payments for unfinished properties is adding now to the challenges facing Beijing. Ninety One's Mr. Cunningham said the risk "of a change in psychology for the housing market" that could lead to a more prolonged downturn is a major headache.

Others see Beijing's COVID-19 lockdowns as the more immediate threat for Chinese consumers.

Lockdowns of Shanghai and other cities caused China's year-on-year GDP growth for the quarter ended June 30 to plunge to 0.4% from 4.8% for the prior quarter. As long as lockdowns remain the prime arrow in the country's pandemic policy quiver, the healthy consumer sector needed to sustain China's economic growth will prove elusive, wrote Preston Caldwell, Chicago-based head of U.S. economics and chair of the China Economics Committee at Morningstar Inc., in an August report.

China's COVID-19 policy appears to have become the principal driver of broader market movements this year, with the waxing and waning of lockdown activity tracking fairly well with performance, Mr. Huang said. For example, stock prices jumped in June as Shanghai emerged from its lockdown and then, as new lockdowns were imposed elsewhere in July, most recently in provinces such as Hainan, shares have given back some of their recent gains, he said.

If property woes pose the more systemic risk, the country's disruptive COVID-19 policies are the easier of the two trouble spots to address by decree, with a number of analysts predicting Beijing will loosen its policies after Mr. Xi, as expected, claims his third five-year term as China's president at the country's 20th National Party Congress in November.

Still, many market participants see Chinese stocks offering relative charms for portfolios now within the global equity opportunity set.

Erik L. Knutzen, managing director and chief investment officer of Neuberger Berman Group LLC's multiasset business, said the balance of COVID-19 policy and property-related risks on the one hand and the government's significant stimulus policies on the other have left his team "neutral on China equities" for now. But with his portfolio's underweight to equities globally, that neutral position can be seen as a relatively favorable view on Chinese stocks, he said.

Meanwhile, Neuberger has begun deploying index options as a relatively "capital efficient, low-cost way" to capture potential upside associated with policy announcements from Beijing, he said.

Ninety One's Mr. Cunningham likewise said his team can make a case now on a three- to five-year horizon for a number of Chinese stocks, something that would be difficult to say about many U.S. stocks against the backdrop of a looming recession.

Weiss' Mr. Edwards said he likewise remains positive on the outlook for Chinese stocks. The initial pop from oversold levels in May or June has given way to an "EKG chart in an upward sloping channel," he said. But with Beijing's determination to support the economy, investors would be well advised to buy the dips, he said.