China's Lockdowns: Another Potential Source of Falling Uncertainty

If we were allowed just two words to sum up the reaction from commentators we follow to China’s Q1 gross domestic product release (GDP, a government-produced measure of economic output), they would be yah and but. As in, yah, that 4.8% y/y growth beat financial analysts’ expectations and is mostly in line with the government’s target, but that was before half the country went back into lockdown.^[i] We think this is a fair point, and the risk of a contraction in Q2—which some financial commentators we follow now forecast—is also worth considering. In our view, China’s economic and COVID setbacks likely add to this year’s early uncertainty—yet we think they also create opportunities for uncertainty to fall later this year as early headwinds will likely fade. Our analysis shows high and falling uncertainty is often positive for stocks, and we think it is likely to be a tailwind as 2022 rolls through its back half.

Whilst we agree with those who state China’s Q1 data don’t give much insight into the latest lockdowns’ impact, we think the accompanying March monthly data offer some clues. Unsurprisingly, in our view, they show the restrictions hitting consumer activity hardest. Retail sales fell -3.5% y/y and -1.9% m/m, with the latter (and month-over-month data in general) featuring rather prominently in the National Bureau of Statistics’ (NBS) release.^[ii] As always, we think it best to take that with a grain of salt, as China’s seasonal adjustment methodologies are young and unproven, but, in our view, it seems rather telling that official releases aren’t shy about presenting negative data. In years past, many of their releases have presented a more positive view, and financial commentators we follow have long suspected that the calculations used to adjust for inflation massaged the data, making them look better than they otherwise might. Before he became prime minister, Li Keqiang fed this suspicion, calling the country’s economic figures “man-made” and encouraging observers to look beyond headline data in order to get a true look at China’s economic health.^[iii] Data releases presenting negative month-on-month data strike us as a break with this recent history. We think the presentation of these figures will also give us a chance to more clearly assess the damage as lockdowns spread from Shenzhen to Shanghai in late March, reaching dozens of other major cities in April.^[iv]

Developments in industrial production will also be worth watching, in our view, as it held up fairly well thus far. Heavy industry grew 6.5% y/y in Q1 overall, with industrial production up 5.0% y/y in March.^[v] It also eked out 0.4% m/m growth, but that coincides with the early parts of Shenzhen’s and Shanghai’s lockdowns, when factories were still managing to operate as bubbles and keep output flowing.^[vi] More recent reports indicate supply chain troubles have prevented factories from getting components, so industrial production could very well take a hit in April.^[vii] Same goes for exports, which jumped 10.7% y/y in Q1, including a 12.9% y/y rise in March (China doesn’t publish month-over-month trade data yet).^[viii] If factories can’t assemble final goods for shipment overseas, then exports will probably weaken. Imports, however, we wouldn’t suggest reading too much into. Ordinarily, we would interpret their -1.7% y/y drop as a potential sign of weakening domestic demand, but the global supply chain weirdness that has companies opting to ship empty containers back to China rather than wait to load them up continues.^[ix] In our view, that is probably skewing the data to an extent.

Regardless, it seems obvious to us that locking down major cities and anywhere from one-third to half the population, depending on who is counting, will do some economic damage.^[x] China’s national lockdown in early 2020 caused a contraction, and this could, too.^[xi] That is a negative. Yet we think there are also some factors that are likely to help mitigate the market impact. For one, when China locked down in 2020, the rest of the world did, too—if only China had gone that route, we think the world could very well have avoided a global recession.^[xii] In our view, that is key because China is now the only major nation pursuing a zero-COVID strategy.^[xiii] The US, UK, Europe, Japan and Australia have mostly moved on.^[xiv] All of these economies are heavier on services than physical goods, which should help limit the impact of disrupted manufacturing in China.^[xv] There will be winners and losers, but for now, we think the net balance is likely to remain positive.

Two, in our view, stocks now have a solid blueprint for lockdowns—they aren’t the mystery they were in early 2020. We know they hit output hard.^[xvi] But based on data from China, the UK, the US and elsewhere, we also know there is usually a strong rebound once economies reopen, and activity gets delayed rather than erased. We think that points to a big catch-up boom in May, June or whenever the national government in Beijing lets cities reopen, especially if that comes with a big side of government financial aid ahead of this autumn’s National Party Congress, where Xi Jinping is reportedly still seeking an unprecedented third term as party leader and Chinese president. As we type, there are already reports the government has begun rolling back restrictions in Shanghai.^[xvii] Perhaps this trend persists, perhaps it doesn’t. But past lockdowns haven’t lasted long.

In our view, this matters because our research shows stocks look about 3 – 30 months out, pricing in expected events over that span. If improved Chinese growth relative to present fears is the likely scenario in that window, which we think it is, then it probably adds to global economic tailwinds and helps reduce uncertainty. By then, we will likely have more concrete data showing how the Western world is coping with the dislocations from the war in Ukraine, not to mention falling political uncertainty as the French and Australian elections resolve, followed by US congressional (midterm) elections’ likely gridlock boost later this year. The mere prospect of clarity on all of these fronts should help bring markets relief, in our view.

We think even a Chinese economic contraction can help uncertainty fall. In our view, getting the numbers will answer the how bad is this? question. We think it lets businesses and investors move on to the next thing. And if some market negativity accompanies or precedes it, then people can have their I was right! moment, too—more moving on.

So, we don’t suggest dwelling on what just happened or what could happen tomorrow. We think investors benefit more from looking where markets do, at the next 3 – 30 months, and getting ready for falling uncertainty.