China turns the corner on epidemic and ‘new economy’ sectors lead the way

Global stock markets sold off en masse on Monday and Tuesday (February 24 and 25), on reports that confirmed cases of coronavirus (COVID-19) had spread significantly outside of China to Japan, South Korea, Italy and Iran. The World Health Organization said Monday that confirmed cased had nearly reached the 80,000 mark globally, 10 times the number of people that were infected by SARS in 2003. Unsurprisingly, equity benchmarks across Asia, Europe and the U.S. sold off indiscriminately while investors sought the safety of US Treasuries and gold. The spike in the number of confirmed cases in Italy in particular spooked complacent investors who until recently figured the pandemic was mostly contained to Asia, and China in particular. The U.S. CDC (Centers for Disease Control) followed up with the grim announcement Tuesday that the country is preparing for the onset of a pandemic, subtly concluding that regarding the spread of the virus across the country it’s not a matter of ‘if’ but rather a “question of when.”

While the world braces for a wider global contagion than previously anticipated, good news can ironically be found in China, where confirmed cases have now begun what appears to be a steady decline. On Monday Chinese health officials said that existing confirmed cases had fallen by 2,152, the sixth consecutive day with declines of at least 1,000 cases. Also on Monday, newly cured cases reached a new high of 2,589 while newly reported deaths reached their lowest point since January 31¹.

As China turns the corner, investors turn their focus to the damage done to the Chinese economy and the impact it will have on the global economy. Some economists estimate the year-over-year decline in China’s first quarter GDP could be as high as 10%, while reports from Mainland sources suggest the government is likely to report first quarter growth in the 2-4% range, well above what most observers outside of China think is plausible. In our view, though, rather than focusing on hard to gauge official reports, it’s worth taking a look at how the Chinese stock market has reacted to the crisis to draw conclusions about the ongoing transformation of China’s economy from export and manufacturing to consumption and services.

In order to compare ‘old’ vs. ‘new’ economies, we looked at the performance of the Shanghai Composite and CSI 300 Index as proxies for the ‘old economy’ and compared them to the CSI MarketGrader China New Economy Index. Through Monday February 24^th, the Shanghai Composite was down 0.6% since the beginning of the year while the CSI 300 Index was up a scant 0.7%. Both of these market-capitalization weighted benchmarks are dominated by large banks and industrial companies, with state-owned enterprises accounting for over 70% of the CSI 300 Index, the most widely followed benchmark by Chinese investors. The CSI MarketGrader China New Economy Index, on the other hand, is comprised only of companies in the consumer discretionary, consumer staples, health care and technology sectors, by design. And while the index had gained almost 14% year to date through Monday’s selloff, what caught our attention in evaluating its performance through the crisis were the significant differences in performance across its four sectors and what those might be telling us about where the market might go from here.

While initial reports of an unknown respiratory viral outbreak in Wuhan first surfaced on Chinese media on December 12, it took until early the middle of January for the broader public to start thinking about it as a national rather than a local issue. And investors didn’t seem to start pricing into equity values the consequences of potential economic disruptions until January 13, when local benchmarks hit an eight-month high before beginning a steady decline straight into China’s Lunar New Year (Jan. 25^th), the country’s biggest annual holiday. The worst of the news, including mandatory quarantines in Hubei province and the temporary closure of businesses across the country broke in the middle of the holiday, during which Chinese markets were closed for the entire week of January 27^th. When stock markets finally reopened on February 3, after an extended two-and-a-half-week closure, the Shanghai Composite and the CSI 300 Index fell over 12% from their January high. The CSI MarketGrader China New Economy Index peaked a few days later, on January 20, but its peak to trough drop matched the 12% decline in the larger Mainland benchmarks.

Among the four sectors in the CSI MarketGrader China New Economy Index, consumer stocks were hit the hardest, with the Consumer Staples portion of the Index falling 16.3% and Consumer Discretionary falling 13.7%. Technology stocks, which had been the best performers to start the year, fell 9.5%. The standout sector was Health Care, which lost a mere 5.4%, significantly outperforming the other ‘new economy’ sectors and the overall market. In hindsight, the difference in performance across these four sectors once the seriousness of the epidemic became clear makes perfect sense. Consumer names, unsurprisingly, took the biggest hit as travel was drastically curtailed, public gatherings were eschewed or outright forbidden and people remained in their homes and away from restaurants, supermarkets, entertainment venues, movie theatres and shopping malls. Health Care names, on the other hand, were quickly seen by investors as clear potential beneficiaries not only of a significant spike in spending on medical supplies, medicines, medical equipment, vaccines and medical care in general, but also as beneficiaries of significantly higher health care expenditures by the national and provincial governments well into the future. In fact, two members of the CSI MarketGrader China New Economy Index (Hualan Biological Engineering and Chongqing Zhifei Biological Products), were mentioned by China’s Vaccine Industry Association to be among the country’s companies working on the development of the COVID-19 vaccine.

Equally telling about the continued bifurcation of China’s economy—and financial markets—into ‘old’ and ‘new’ economies has been the performance across sectors during the rebound that followed the initial panic selling. After the post-Chinese New Year market bottom on February 3, the Shanghai Composite and CSI 300 Index have risen 10.4% and 12% respectively, while the CSI MarketGrader China New Economy Index gained 18.2%. Figure 1 illustrates the difference in performance between the New Economy Index’s sectors and the ‘old’ economy sectors within the CSI 300.

Figure 1. Performance for China’s ‘Old’ and ‘New’ Economy Sectors February 3 to 24

^{*The CSI MarketGrader China New Economy Index is comprised, in equal proportions at the beginning of each semi-annual rebalance period of the four underlying MarketGrader China New Economy sectors.
Sources: Bloomberg, FactSet.}

While China—and the rest of the world—have a long way to go before the coronavirus epidemic is finally overcome, performance of the old and new economy sectors in China during this short period offer another clear example of the economic bifurcation underway in the country. Consumer sectors rebounded strongly after posting some of the biggest declines during the selloff, while technology continued to lead all sectors as investors anticipate higher investment on domestic technology providers the U.S. and Chinese governments remain at odds about the development of this key sector to the world’s two largest economies. And now Health Care is once again front and center in investors’ minds as it is clear government spending in the sector is very likely to rise significantly in coming years; especially considering that two deadly global epidemics originated and spread from China in the span of less than 20 years. Investors looking for a long-term exposure to China’s economic growth and its ongoing transformation could do worse than to stick with the country’s new economy sectors.

1. Source: National Health Commission of China