The China Tailwind in 2023

China announced Q4 and full-year 2022 GDP today, and in a telling sign of sentiment, it was basically an afterthought. Sure, Q4’s 2.9% y/y growth made headlines, as did the 3.0% full-year growth and its big miss of the 5.5% official target.^[i] But most of the China discussion centered on two more forward-looking factors: news that the population declined in 2022, allegedly signaling that the One-Child Rule’s chickens are about to come home to roost in the economy, and outgoing Vice Premier Liu He’s big ode to markets, money and the private sector at Davos today. The general reaction? Soliciting private capital—and promising that the government isn’t interested in central planning—risks being cheap talk and too little, too late to overcome declining productivity and demographic challenges. We can’t think of a better sentiment backdrop for stocks.

Even if you don’t invest in Emerging Markets, China matters. It is the world’s second-largest economy and therefore a key contributor to global GDP.^[ii] It is also a key link in the global supply chain, making its Zero-COVID policy a pretty big global headwind until officials lifted it late last year. Intermittent factory and port closures bore much of the responsibility for global shortages and disruptions in freight traffic, both of which contributed to inflation (and stocks’ inflation freakout) in the developed world. Because of its importance, sentiment toward China’s economy—and how reality eventually squares with that—affects developed-world markets.

These days, the gap between sentiment and reality looks quite wide. Zero-COVID may be over, but with the virus’s winter wave still barreling through major cities, few expect an economic recovery before spring at the earliest. Even then, very few see a fast snap-back. Not with demographic challenges now seemingly setting in. As for Liu’s overture to the World Economic Forum, attendees and analysts largely wrote it off as lip service. Some speculated that it couldn’t carry much weight since Liu is retiring in March and his replacement is likely to be one of President Xi Jinping’s loyalists—someone who doesn’t hail from the Chinese Communist Party’s more market-oriented Youth League faction. Others noted that for all the nice-sounding nostrums, Liu also stuck to buzzwords like “common prosperity,” which has come to mean more redistribution and central planning and has long been associated with the regulatory crackdown on China’s Tech and Tech-like companies.

Yet he also seemingly tried to redefine the term, saying: “Common prosperity is by no means a synonym of egalitarianism or welfarism. As China grows, all Chinese people will be better off, but that doesn’t mean their incomes and level of prosperity have to be the same. (That is to say, there will be equal opportunities, but no guarantee of equal outcomes.) Entrepreneurship is a key factor for wealth creation of a society. Therefore, entrepreneurs, both Chinese and foreign, will play an important role as the engine driving China’s historical pursuit of common prosperity. If wealth doesn’t grow, common prosperity will become a river without source or a tree without roots.”^[iii] Given how coordinated China’s policy announcements have been lately—and how much Xi has consolidated power—it seems highly unlikely Liu was speaking out of turn.

Still, we agree some skepticism is logical. Watch what they do, not what they say is always a good approach in any country. Yes, official mutterings about easing COVID restrictions translated to actual action, as did veiled pledges to support the economy and property developers. The smorgasbord of policies announced on those fronts the past several weeks are concrete and should bear fruit. At the same time, while the central government has tried to signal that the regulatory crackdown is over, it is also taking official stakes in the affected Chinese companies—stakes that come with special voting rights giving the government a heavier say over business decisions. So we agree, a speech from one outgoing official isn’t an all-clear sign that intervention is out and markets are in. However, it does mesh with more efforts to support businesses and private financing, which the People’s Bank of China has also stressed recently. The consistency is encouraging.

As for demographic concerns, those aren’t new. Investors have seen them coming for decades—demographic changes are generally too well-known and slow-moving to have much market effect. There are also some mitigating factors that get much less attention. Like: China still has nearly half a billion people living in the countryside, which is a vast untapped well of human capital. Continued urbanization over time could offset the real impact of the decline in the working-age population. So could technology, automation, an increased shift from manufacturing to services and even good old-fashioned higher birthrates, which are possible now that the One-Child Rule is no more. Mostly, with everyone saying the economic challenges are now manifesting, we think it just lowers the sentiment bar that much further.

Besides, markets don’t look far to the future. They look 3 – 30 months out. So what matters is what people expect and whether reality is likely to beat that. We see a high likelihood it will. With the Davos audience calling Liu’s speech “too good to be true,” it probably won’t take a full-throated embrace of capitalism to surprise positively. A return to the pre-COVID way of doing business in the country—or something close to it—would likely more than suffice. As for the pure economic data, we are already seeing reality beat. Look at December retail sales, which fell just -1.8% y/y, smashing expectations for an -8.5% drop.^[iv] Total trade in goods managed to grow 7.7% last year—even with lockdowns and supply chain kinks—fruit of businesses’ creativity and perseverance in the face of big challenges.^[v] High-tech manufacturing remained heavy industry’s growth engine, a sign of continued advancement that counters all today’s claims about China’s development stalling. While services were weaker overall, high tech-related services grew nicely. In other words, the areas one would rightly see as China’s future are doing quite well indeed. Those that are more tied to China’s past are the laggards. That is what we would expect for a country following the tried-and-true economic development path.

GDP growth probably won’t return to the fast rates of old, but it doesn’t need to. Just modestly better than expected is good enough for China’s contribution to global GDP to surprise global observers this year. The baseline expectation seems to be a struggling economy hampered by demographics, COVID challenges and government policy. Looking at the data in detail, it seems to us that China is already exceeding this low bar. As the world gradually realizes this, falling uncertainty should be a nice tailwind.