Why betting on recovery in Chinese property stocks requires a leap of faith

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Over the past several months, a growing number of prominent Wall Street firms have turned bullish on China’s beaten-down stocks. They sense a turning point in a market that has suffered simultaneous shocks, resulting in attractive valuations and the prospect of more forceful measures to shore up growth.

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More tellingly, sentiment towards the property sector – the largest driver of China’s economy and the acid test of the government’s efforts to reduce corporate indebtedness and social inequality – is no longer as bleak as it was towards the end of last year.

An exchange-traded fund that tracks the performance of Asian high-yield bonds, nearly 30 per cent of which are issued by Chinese real estate developers, has stopped falling precipitously and has been volatile since last October, even rising more than 4 per cent since January 17.

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Markets, which are forward-looking and move on what investors expect to happen in six to 12 months’ time, have entered a phase of intense speculation over the scope for a policy-induced rebound in property assets.

There are good reasons to want to correctly anticipate a recovery in China’s real estate sector. Successfully calling the bottom of the market could prove to be one of the most lucrative trades this year.

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A sustained rally in property assets would help restore confidence in an industry that continues to pose a severe threat to China’s markets and economy. It would also create a rare opportunity for investors to capitalise on policy support at a time when central banks the world over are starting to withdraw stimulus.

However, betting on a meaningful and durable recovery in Chinese real estate stocks and bonds requires a leap of faith, one that few investors have been willing to take. While the steep declines in property assets have abated somewhat since last November, the more lenient tone on the part of Beijing – underpinned by a series of measures to loosen policy – has done little to turn sentiment around decisively.

The benchmark CSI 300 index of mainland shares has lost almost 10 per cent since December 9 and the average yield on a gauge of junk-rated dollar-denominated Chinese bonds – which is dominated by property developers – stands at a prohibitive 22 per cent. Most worryingly, the liquidity crisis has engulfed higher-quality private developers such as Shimao Group Holdings.

Part of the problem is that, while investors anticipate further easing measures, there is a conspicuous lack of conviction on the scope and efficacy of a reversal in housing policy. This is because the government’s response has become a delicate balancing act. While Beijing continues to ease restrictions on the market, it remains committed to reducing leverage in the sector and discouraging speculation.

The confusion over the direction of policy is exacerbated by the opacity of China’s vast real estate industry. The rapid unravelling of the finances of China Evergrande Group, the world’s most indebted developer, opened a can of worms, casting doubt over the true scale of the sector’s liabilities, even those of stronger developers.

The problems “go far beyond Evergrande”, said Jim Veneau, head of Asian fixed income at AXA Investment Managers in Hong Kong.

The fact that the auditors of some of the highest-rated developers resigned in recent weeks attests to the lack of transparency in the sector. Of particular concern is hidden debts – such as private bonds and trust loans – that receive preferential treatment over obligations owed to foreign creditors, fuelling concerns about poor disclosure and making it less likely that offshore funding markets will reopen any time soon.

The persistence of funding stress increases the risk of further defaults. Chinese developers, which according to JPMorgan accounted for a staggering 97 per cent of Asia’s distressed corporate bonds at the end of 2021, need to repay or refinance nearly US$100 billion of debt this year. Half of that is outstanding dollar debt, according to Bloomberg data.

Even if Beijing steps up support for the sector more aggressively, the damage is already done. Confidence among homebuyers, investors, creditors and local governments continues to erode. Home sales – the proceeds from which make up more than half of builders’ cash inflows – contracted for a seventh straight month in January.

Given the sharp volatility in real estate assets, opportunities abound for hedge funds and other distressed debt investors to profit from the mispricing of risk. Yet, for most institutional investors, caution is the watchword given the absence of a clear catalyst for recovery in the sector.

Indeed, given the mounting distress and the costs of clamping down on the excesses of a sector that accounts for about 30 per cent of China’s output, investors need to reassess the financial and economic underpinnings of the property market. “We have had defaults. Everything now needs to be repriced,” Veneau said.

Predicting the direction of markets is extremely difficult. It is possible that overly cautious investors in China’s real estate sector will miss the turning point for asset prices. Yet, those who turned bullish on China late last year have little to show for it. This is mostly because of the lack of policy clarity and transparency in the all-important property sector.

Nicholas Spiro is a partner at Lauressa Advisory

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