With protests and an economic slowdown, how should investors think about China?

Open this photo in gallery:

Angry demonstrations in China over the country’s harsh zero-COVID policies stand little chance of toppling the country’s authoritarian government, but that doesn’t mean they won’t reverberate in your portfolio in more subtle ways.

From oil prices to metal prices, much depends on the highly uncertain outlook for what Chinese leaders decide to do next. So, too, do the prospects for Chinese stocks.

For now, stock markets seem oddly exuberant despite the wave of popular anger. The Hang Seng Index, which tracks large companies on the Hong Kong stock market, gained 20 per cent in November.

Investors seem to be betting that mobs in the street will force Beijing to relax its hard line stance against COVID-19.

The core argument in the bullish camp is that the level of mass outrage leaves Chinese leaders with limited choices. According to this line of reasoning, Chinese President Xi Jinping will have to relax restrictions on free movement and reopen the Chinese economy over the next few months despite the country’s most widespread outbreak of the virus since the start of the pandemic.

If this does happen, Chinese stocks could soar in value because they are extremely cheap. They have lost roughly a third of their value since the start of 2021, thanks in large part to Beijing’s policy of endless COVID testing and intermittent lockdowns of major cities. They now trade at only about 10 times their forecast earnings for next year, considerably less than stocks in Canada or the United States.

The catch is that these apparent bargains may be cheap for good reasons. Those skeptical about an early reopening emphasize the depths of the country’s problems, ranging from a surging number of COVID infections to a deflating property bubble.

China Beige Book International, a U.S.-based observer of the Asian giant, says its data show the Chinese economy was “barely treading water” in November.

“Every key business performance deteriorated … as exports weakened and domestic consumption stalled,” the firm wrote in a note this week. “Every sector is currently trending toward double-digit year-over-year growth declines, putting true 2022 GDP growth laughably out of the government’s target range.”

Chinese leaders have no great options, according to Mark Williams, chief Asia economist at Capital Economics.

The problem, he told a webinar this week, is that the country’s reliance on lockdowns to stop the virus has left China with low vaccination rates, especially among the elderly. If Beijing were to relax restrictions and let the virus rip through the population, it lacks the medical capacity to deal with the massive wave of infections that would result.

The most likely outcome is for China to keep restrictions in place for now and embark on an aggressive vaccination drive that would result in an eventual reopening of the economy – but in 2024, not in the next few months, Mr. Williams says. He cautions that China could lose control of the situation and be forced back into a countrywide lockdown if it were to attempt an early exit from its current COVID containment measures.

If Mr. Williams is right that any reopening still lies well into the future, the most immediate impact of China’s troubles may be on global oil prices. The country accounted for 16 per cent of the world’s oil consumption in 2021.

That consumption could abruptly fall if Beijing decides to ignore the mass protests and reinstitute full zero-COVID restrictions to deal with the latest surge in cases.

In that scenario, traffic would fall and Chinese consumption of oil could easily tumble by a million barrels a day in December compared with November levels, Capital Economics says. On paper, a sudden fall in demand of that magnitude would be enough to knock US$5 to US$10 a barrel off the price of Brent oil. Granted, it’s not clear that such a fall would actually occur – major producers might just decide to cut supply instead – but, still, the downward drag would be considerable.

Many investors, though, seem to be betting that trends will bend in the opposite direction. Global prices for iron ore rallied in November as investors grew increasingly confident that Beijing would come to the aid of its property sector and reopen the economy despite the surging number of COVID cases.

The market is “looking through” the dire short-term situation in China and rallying as investors anticipate an eventual economic reopening over the next six to 12 months, Wenyu Yao, an analyst at Citibank, wrote in a note this week.

The optimists may turn out to be right. However, they might want to keep in mind a grim forecast from China Beige Book. “November is not typically the COVID peak, that comes in winter,” it wrote. “The first quarter of 2023 could therefore be worse still.”

Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.