China’s Woes Extend Beyond Its Dismal Stock Market. Covid, the Economy and Russia Pose Problems.

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Russia’s invasion of Ukraine is prompting a rethink of China, which could push emerging markets investors to other regions.

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China’s growing economic woes and “strategic neutrality” in the war in Ukraine and coziness with Russia has led some investors to stay clear. But China still poses a problem for investors, companies and other countries that still look to China as a major engine of growth.

Central to the problem is just how integrated China has become in the fortunes of companies and countries—an increasingly uncomfortable reality, especially as China overnight told Russia it would increase “strategic coordination” with the country even as the U.S. and allies increasingly ostracize Russia with sanctions for its actions in Ukraine.

Continued angst over Beijing’s crackdowns on the technology sector, the country’s shift toward self-reliance and common prosperity, and economic damage from its zero-Covid policy had already made some investors jittery.

And Russia’s invasion of Ukraine is prompting a big rethink of China, which could push emerging markets investors to other regions, the Institute of International Finance’s Robin Brooks wrote on Twitter on Wednesday. Latin America, for example, saw inflows of $10.8 billion in March while Chinese equities saw $6.3 billion in outflows and Chinese bonds logged $11.2 billion in outflows, according to the IIF.

Beyond the geopolitical ramifications, China’s economy is still struggling and policy makers haven’t rolled out the type of stimulus that can steady the situation. Bank of America ’s economics team sees earnings growth headed to recession levels this year, much lower than consensus estimates for 15% earnings growth.

While policy makers have stressed their ambitious economic growth target of 5.5% and tried to reassure investors last month with talk of stimulus and regulation winding down soon, BofA strategists wrote that regulatory scrutiny continues, and property developers are still finding it difficult to get funding—yet the leaders have been reluctant to ease policy as they grapple with China’s debt load.

Bank of America’s Asia-Pacific equity strategy team has been neutral on Chinese stocks—seeing little reason to add to them—since Beijing ramped up its crackdown on the private sector in late 2020. They cited concerns that President Xi Jinping’s shift last year to focus on common prosperity and self-reliance could hamper profits and Chinese stocks. Xi’s zero-Covid policy has pushed key economic centers into lockdown, adding to the pain as it hobbles factory production and supply chains and further dents services.

Companies are left to deal with potentially higher costs as the lockdowns gum up already disrupted supply chains, adding to logistics issues and parts shortages that translate into higher costs.

While companies have not made major inroads in diversifying supply chains, despite the talk of doing so during the trade war and pandemic, the confluence of challenges in China could force companies to take a harder look at building some resilience into their supply chains—likely resulting in higher costs that dent profitability. Add in softer demand from China and the outlook for some Chinese stocks, as well as regional and global companies reliant on China, becomes murkier.

In a note to clients, Pantheon Macroeconomics’ Chief China+ Economist Craig Botham writes that China’s economy is likely to slow further next month amid the lockdowns, and congested shipping traffic could disrupt Japan’s trade with other countries. Already, he notes, it contributed to a slowdown in Japanese exports in March.

Bank of America’s strategists see China’s woes also impacting the outlook for Taiwanese and Japanese parts and OEM suppliers for smartphones and PCs. Add to that list: Japanese electronics companies—with China accounting for 40% of their factory automation sales; Asian chemical makers, and Australian infant formula companies.

Weak demand lasting later into the year could also hurt smartphone and PC demand, adding to the pain for companies like Xiaomi (1810.Hong Kong), which is more concentrated in China.Though Taiwanese suppliers may be able to manage the short-term disruption since it’s currently low season for the industry, BofA strategists note that surging Covid cases in cities like Guangzhou, and the continued lockdown in Shanghai suggest higher operation costs from labor and logistics and lowered utilization rates are likely inevitable.

In a screen of Asia-Pacific companies that generate more than 10% of sales from China, materials companies like BHP Group (BHP) and Rio Tinto (RIO) topped the list, getting more than half their revenue from China. But more vulnerable companies may include those like Japan’s Fanuc (6954.Japan) and Nippon Paint Holdings (4612.Japan), and Korea’s SK Hynix (660.Korea) and Taiwanese plastics companies like Nan Ya Plastics (1303.Taiwan) and Formosa Plastics (1301.Taiwan)—all of which get a third or more of revenue from China.

Write to Reshma Kapadia at reshma.kapadia@barrons.com