Checking the temperature of the Chinese consumer

COVID-19 cases are thankfully falling now in China, but taking a step back from the daily data makes one realise just how severe this latest outbreak has been:

Could it result in more damage to consumption than that of 2020?

Weekly logistics data can shine a light on the true impact of the lockdowns. Bank of America numbers show that throughput declined sharply into mid-April (to the lowest levels since mid-2020, except Lunar New Year holidays).[1]

The developed regions of Shanghai and Shenzhen have been hit hard, with Beijing bearing the brunt more recently. These areas act as economic engines for the country, so efforts to suppress the virus have resulted in significant pressures on both demand and supply. Availability issues and store closures are also weighing heavily on consumer confidence.

It is important to think about what exposures each affected city has – for example, many gold product processing factories are in Shenzhen, which has implications for global supply chains in both gold and jewellery.

Retail sales slump

In February, China’s retail sales were booming, up +6.7% year-on-year and well ahead of market expectations.

However, as the Omicron variant spread widely in March, retail sales were down -3.5% year-on-year, and April was even worse: down -11.1% year-on-year. If we strip out inflation, April’s sales worsen to -14% year-on-year.

As seen during lockdowns elsewhere, discretionary spending declined, with categories such as clothing down -23% and gold and jewellery down -27%. The bright spots remained staples, which held up well[2], and which could therefore in our view prove more defensive in the coming months.

Looking ahead, we believe it’s likely the next few months will remain very difficult for the Chinese consumer industry, especially catering and retailing.

Company results take a hit

It won’t be until the next results season that we see all this truly reflected in company earnings. However, the challenging operating environment shone through even in Q1 results.

To give two examples, cosmetics company Estée Lauder* and luxury group Kering* both flagged issues with their Chinese operations.

Estée Lauder cited supply issues in their distribution hub in Shanghai and had to cut full year guidance. Kering’s Gucci brand sales slowed more than expected as its stores in affected cities witnessed sharp drops in traffic, on top of logistics disruptions.

Companies’ overall tones are optimistic about the outlook for Chinese demand rebounding when lockdowns ease. Before then however, there is likely pain to come in Q2’s results.

Falling valuations

Valuation multiples have come down in reaction to the outbreak. Once the market is convinced that China is to re-open fully, it’s possible the discretionary sector will experience a rapid valuation re-rating, although any improvements to the fundamentals could take longer.

This means it’s crucial to closely monitor case data and policy responses for incremental signals of market re-opening. So far, the signals are becoming increasingly more positive – but there’s a long way to go.

‘Zero COVID’ to continue

It became clear at April’s Politburo meeting that the Chinese government is determined to stick to its ‘zero COVID’ strategy.

However, there are signs it is scaling back some of the more draconian measures that could hamper an economic recovery. On June 1, we saw steps towards re-opening in Shanghai, as well as supportive financial policies for businesses and consumers.

The government appears to have realised it needs to work with, not against, Chinese internet platforms for economic recovery. These companies have had a tough time recently, whipsawed by changing market views on whether or not the authorities are clamping down on them. Yet in the more virtual post-pandemic world we now live in, these companies are likely to all have essential roles.

For example, the government is now using them to distribute stimulus measures in the form of consumption vouchers, as we have seen on online retail platforms Meituan* and JD* in Shenzhen. It’s possible that future rhetoric and policies could be more accommodating to these consumer enablers than before, leading to less regulatory overhang.

‘Re-opening’ trade

This outbreak has damaged the green shoots of recovery that were starting to emerge in China. It is premature to estimate the actual impact to consumer companies, as the situation is still evolving, but we favour positioning cautiously into the next results season.

Once there is more certainty around China’s COVID situation, we believe the beaten-up pockets of Chinese consumer stocks, which are trading at lower valuations than before, could present opportunities as proxies to play the ‘re-opening’ trade.

* For illustrative purposes only. Reference to this and any other security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. Such references do not constitute a recommendation to buy or sell any security.

[1] BofA - Equity Strategy - China (baml.com)

[2] Source for all retail data: Bloomberg as at 1 June 2022