Investors are eyeing China’s neighbors as the recovery from ‘zero-Covid’ slows

China’s lackluster economic recovery since emerging from strict “zero-Covid” lockdowns has caused weaker sentiment toward the country, prompting investors to look for alternative options — like its near neighbors.

In particular, stock markets in Japan, South Korea and India have all been major beneficiaries of the disappointment from China’s reopening, highlighted by softer-than-expected data from the world’s second-largest economy.

“Amid China weakness, investors have looked elsewhere in the region for opportunities,” Goldman Sachs Chief Asia-Pacific Economist Andrew Tilton said in a Friday research note, adding that Japan “is in the limelight” while India has “also returned to focus in recent months.”

The Nikkei 225 is in bull market territory, up by more than 23% year-to-date thanks to garnered interest from foreign investors, including Berkshire Hathaway’s Warren Buffett.

India’s Nifty 50 index has rallied nearly 7% so far this quarter and pared all of its losses from its March low, while South Korea’s Kospi index has risen 18% year-to-date.

That shows a stark contrast to a sell-off seen in the Chinese stock market. The CSI 300 index, which measures the largest companies listed in Shanghai and Shenzhen, has fallen 5.29% quarter-to-date and has erased all of its gains seen earlier in the year, when stocks rallied on reopening momentum.

The Hang Seng index also touched bear market territory last month and is down nearly 2% year-to-date, Refinitiv data shows.

“Investor sentiment on China has weakened further, and in our view is around rock-bottom levels we’ve only seen a few times over the past decade,” Goldman Sachs’ Tilton said in the note.

Foreign investors have undoubtedly been key in driving the Japanese market, maintaining the highest levels the Nikkei has seen since 1990.

The latest data from Japan’s Ministry of Finance shows overseas investors continue to build on their Japanese equity positions as domestic investors remain the net buyers of foreign bonds.

Foreign investors bought a net 342.18 billion Japanese yen ($2.45 billion) of stocks in the week ending June 2, according to a Reuters calculation, totaling roughly 6.65 trillion yen of net purchases of Japanese shares this year. During the same period last year, foreign investors had sold a net 1.73 trillion yen approximately.

Wall Street banks including Morgan Stanley and Societe Generale are among those that are optimistic on Japanese stocks, holding “overweight” positions.

In its global mid-year outlook, Morgan Stanley predicted Japanese stocks will outperform their global peers: “Japan is our most preferred region, with improving ROE [Return-on-Equity] and a superior EPS [earnings per share] outlook,” Chief Investment Officer Mike Wilson said.

The firm raised its estimates for the Topix index to rise 18% by June 2024 from its previous target of a 13% gain.

“Japan [is] looking even more attractive, while we hold a preference for EM [emerging markets] versus the U.S. and EU,” Morgan Stanley strategists said in a note, adding that “accelerating regional growth and solid domestic GDP should support earnings” for Japanese companies.

South Korea is another market closely watched as concerns over China’s recovery linger.

Korean technology stocks, which make up roughly half of the Kospi 200 index, have been the main driver behind UBS Global Wealth Management’s “most preferred” status on the sector and its market.

Noting that the bank expects U.S. interest rates to peak soon followed by a drop in the U.S. dollar, UBS wrote in its monthly outlook: “We remain most preferred on Asia semiconductors over the next 3-6 months and Korea, which we’ve previously highlighted as a winner in such an environment.”

South Korean technology stocks’ low price-to-book ratio makes it “an attractive alternative to more expensive tech segments,” UBS said, noting that there is still “significant value” seen in China’s e-commerce stocks, which have plunged 20% year-to-date. Price-to-book ratio is an important metric used by traders to gauge the value of a stock.

“For China, questions continue over the durability of its economic recovery. This, and ongoing geopolitical concerns, have weighed on the market,” UBS strategists said in the report.

Goldman Sachs is also confident in the South Korean market, expecting more overseas investment ahead.

“We are relatively bullish on Korea both because we are less concerned about broader domestic spillovers from housing sector weakness and more optimistic about foreign portfolio inflows,” Goldman’s Tilton said.

The Bank of Korea, meanwhile, is expected to be one of the first central banks to deliver a monetary policy pivot, despite its governor Rhee Chang-yong telling CNBC that it’s still “premature” to be discussing a rate cut.

Banks including Citi and Nomura are expecting to see a rate cut of 25 basis points as early as the third quarter of this year.

South Korea’s money market fund (MMF) logged a record high at the end of May, data from Korea Financial Investment Association showed. The total MMF assets under management stood at 172.7 trillion South Korean won ($134 billion), or a 22% rise since the end of September last year.

A money market fund is a type of fund that invests in highly liquid, near-term instruments, including cash, and is seen as a place of safety amid a volatile market.

Fitch Ratings Senior Analyst Chloe Andrieu said in a June 8 note: “The increase was driven by institutional investors pivoting assets towards high-quality investments, such as MMFs,” adding that rising interest rates across the world have also contributed to the shift.

In contrast, newly launched funds in China marked the smallest holdings since 2019 for the first five months of this year, having raised a total of 432.1 billion Chinese yuan ($61 billion), according to data from local consultancy Z-Ben Advisors.

There is also growing interest in investing in India, according to Goldman Sachs.

“Clients increasingly ask about India’s potential to benefit from greater investment amid supply chain reconfiguration,” Tilton said. The firm said it is “generally positive in the medium term,” citing India’s continued monetary policies, credit conditions, and its prospects for attracting foreign direct investment.

HSBC’s chief economist for India and Indonesia, Pranjul Bhandari, said ahead of the Indian central bank’s June meeting that keeping rates unchanged would be “allowing the perfect macro mix to continue,” pointing to raised growth and lowered inflation forecasts.

The firm also raised India’s full-year gross domestic forecast for 2024 from 5.5% to 5.8% and expects the RBI to deliver two rate cuts in the first quarters of 2024, bringing its repo rate to 6% by mid-2024.

“India’s economy is much improved from a year ago,” Bhandari said. “GDP growth momentum has been steady as per the latest high frequency data, with the informal sector picking up the slack as the formal sector growth softens,” she said.

The Reserve Bank of India held its benchmark repo rate steady at 6.50% last week for the second consecutive time — in line with market expectations.

The Organization for Economic Cooperation and Development also expects India’s economic growth to outpace that of China this year and next, it said in its latest global outlook report.

“Growth has surprised on the upside recently, and we believe an improving informal sector is at the heart of it,” Bhandari said. “Rising state government spending, and some cushion in the central government budget to support social welfare schemes, is likely to remain supportive of informal sector demand.”