China Uses the Appropriate Tools in Its Kit—What’s Next for Chinese Equities?

As China starts to emerge from the coronavirus crisis, what might a recovery look like?

    Michael Lai, CFA

    Michael Lai, CFA Portfolio ManagerChina Equities Franklin Templeton Emerging Markets Equity

    As markets grapple with the financial impact of the coronavirus outbreak, our Michael Lai, Portfolio Manager, China Equities, Franklin Templeton Emerging Markets Equity, considers what a recovery could look like, and how that might affect Chinese equities. He reports some on-the-ground developments he’s seen from the region, with some creative solutions businesses have introduced to adapt to a new, temporary way of life.

    Investors across the globe are undoubtedly worried about the uncertainty the novel coronavirus outbreak is bringing to financial markets. Yet, the medical crisis that was discovered initially in China and infected more than 80,000 people has shifted to Europe, where there are now more cases being reported daily than at the height of China’s crisis.

    As China recently reported 39 new domestic infections, all of them imported,1 it’s a marked decrease from its peak. In our view, this leaves emerging-market investors wondering what’s next for the stock market from a country which locked cities down and practiced extreme social distancing measures.

    There are two sides to the coin in relation to the current sentiment towards Chinese equities. Domestic sentiment has been a lot more resilient relative to foreign sentiment. The Chinese government has issued a clear policy roadmap and has leveraged all the appropriate tools at their disposal, be it monetary or fiscal policy, and was able to redirect resources to tackle the virus.

    On March 13, the People’s Bank of China (PBOC) cut reserve requirements for banks to free up US$78.8 billion in funds that banks would lend to companies worst hit by the virus outbreak. The central bank also lowered the reserve requirement ratio, a minimum amount of money that banks must hold onto in reserve, by an additional one percentage point. At the outset, some market commentators assumed the virus would be a one-quarter event, but we think it will be at least two quarters before we see a recovery. As such, we have reasons to believe China will make a recovery, though a modest one at best.

    China has had more room for maneuver relative to the constraints Western policymakers are faced with, i.e., low interest rates and constrained fiscal budgets. The current situation remains so fluid that it brings up long-term philosophical questions, for example, on how governments approach a delicate balancing act between civil liberties and the public good. On the other side of the coin, foreign sentiment is, as you’d expect, negative—not just towards China but in general for equities across the globe.

    In our view, investors should stay engaged. A hallmark of what we look for is companies that display the key attribute of sustainable earnings power at a discount to their intrinsic worth.

    Coronavirus Ushers in a New Way of Life

    Questions remain over whether we’ll see a V-, or a U-shaped recovery. Regardless of which letter of the alphabet we use to describe the process, we think there’s been a profound development in the way people live across the globe as social distancing rules are implemented.

    The ramifications from the coronavirus have been widespread—it has changed consumer and corporate behavior, and how the hospitality, travel and leisure sectors work. Though it could take a bit longer, perhaps a year, until we see a long-term impact.

    We’ve observed businesses taking creative solutions to keep business processes ticking along, which translates into opportunities in technology in particular. For example, as more companies move to remote working, we’re particularly interested in companies with data centers to meet a sudden increase in demand for bandwidth. There’s a sense that deglobalization could accelerate because of this contagion situation, which should encourage some tech localization themes that we’ve favored for some time.

    Elsewhere, major on-demand delivery platforms could stand to benefit as there has been a dramatic change in customers’ food consumption over recent weeks. These types of companies have moved to a “contactless delivery” service in the wake of the coronavirus.

    While too early to tell, there are signs that “life” is returning to some companies in China. With the Western world in the midst of what some might call the peak of the coronavirus (or not even there yet in some countries), there will clearly be a knock-on effect of the demand shock. For example, earphone manufacturers in China won’t want to ramp up to full production yet because there’s very little demand for that sort of product right now. That said, we’d expect market consolidation to continue in the near term. Given the current situation, we think we’ll see even more consolidation as weaker companies fall by the wayside.

    The long-term narrative of the Chinese economy remains the same in our view—trends in technology, consumption and market consolidation may be derailed but won’t disappear. We believe these will remain pertinent to equity investors.

    ENDNOTES

    1. China’s National Health Commission, March 22, 2020.