China's post-COVID rally faces reality check as recovery trades grow crowded

In the first week of January 2023, Chinese investors were moving fast. More than thirty new mutual funds launched in a single week, nearly all of them betting on economic recovery now that Beijing had abruptly dismantled its COVID restrictions and quarantine requirements. The Shanghai Composite and CSI300 indices both climbed more than 2 percent in a shortened trading week. Hong Kong's Hang Seng surged as much as 8 percent, reaching its highest point in six months. The mood was unmistakable: China was reopening, and money was flowing into vehicles designed to capture the upside.

The most obvious winners had already moved dramatically. Tourism and hotel stocks had gained more than 20 percent since November. Mainland developers' shares had nearly doubled since the end of October. Sector-specific exchange-traded funds had drawn more than 2.5 billion yuan—roughly $364 million—in net inflows the previous month, as investors sought exposure to technology, new energy, and defense. The appetite for recovery plays felt almost unstoppable.

But beneath the surface, experienced money managers were beginning to sound a note of caution. Qi Wang, CEO of MegaTrust Investment in Hong Kong, warned that travel and leisure stocks had already priced in an optimistic recovery scenario and had become crowded trades. The real estate sector, he noted, faced deeper structural problems. Homebuyers lacked confidence. Prices were not moving. The weakness in property threatened to drag down the broader economy. Wang said he was shifting his focus instead toward advanced manufacturing, healthcare, and internet stocks, where regulatory headwinds appeared to be easing.

Li Xiaohua of Harfor Fund Management had actually increased his exposure to tourism stocks over the preceding months, betting on a reversal of fortune. But he too sensed a shift. The next phase of the market, he believed, would reward companies with solid fundamentals rather than broad sector momentum. Performance would diverge. Winners and losers would separate.

The infection surge itself—hospitals strained, crematoriums reportedly overwhelmed—had not yet dampened the optimism. Liu Guojiang, a fund manager at Tianhong Asset Management, said the sooner China reached peak infections, the better for investors. He expected many regions to hit that peak before the Chinese New Year festival in late January. Yang Delong, chief economist at First Seafront Fund Management, projected China's economic growth would exceed 5 percent in 2023, a sharp rebound from the roughly 3 percent consensus forecast for 2022.

Yet not everyone saw a smooth path forward. Cao Ludi of Fullgoal Fund Management predicted an N-shaped recovery—a spring revival in activity followed by a harsh reality check in the second quarter. She advised investors to avoid chasing the high-flying real estate and tourism stocks, whose fundamentals remained uncertain. The property sector, which accounts for roughly a quarter of the Chinese economy, had been badly damaged in 2022 as cash-strapped developers failed to complete apartment construction. Authorities had pledged support, and economists expected price declines to moderate, but further falls were still forecast.

The reopening was nonetheless drawing foreign investors back into Chinese markets after a year of steady withdrawal. Christopher Wood, global head of equities strategy at Jefferies, recommended betting on the reopening trade through liquid consumption proxies like internet stocks. The virus would likely spread through the population faster than anticipated, he argued, meaning economic recovery could arrive by the second quarter or sooner. The question hanging over all of this was whether the most obvious trades—tourism, property, consumer discretionary—had already captured the gains, or whether the real money was still to come.