China Doubles Population Under Lockdown, at Risk of BA.5 Shutdown

Authorities in China are scrambling to prevent a mass outbreak after the highly infectious BA.5 Omicron variant of Covid-19 started to appear around the country. Shanghai earlier this month conduced three rounds of mass testing for most residents. Xian, with 13 million people, went into partial lockdown, and Beijing has started to record cases of BA.5.

Last week, the number of Chinese cities under lockdown doubled from 5 to 11, with the population shut at home rising from 67.6 million to 114.8 million people, per estimates from Nomura. All told, 14.9% of China's economy is affected, those provinces punching above their weight, since they account for 8.1% of China's total population.

Shanghai thought its nightmare had ended after it finished a two-month hard lockdown on June 1. But residents including long-term expatriates are still leaving China's biggest city, concerned that they can be trapped at home once again should Covid return. It has for two years been virtually impossible to fly in and out of China. Even a reduction in the mandatory quarantine from 14 days to 7 still presents a significant cost-and-inconvenience concern.

China's economy has been recovering since mid-May. But Nomura has described a "Covid business cycle" or CBC that is governed by outbreaks and the shutdown response they provoke. With the surge in Covid cases in Hong Kong and various Chinese provinces, "the risk of the CBC shifting to a downswing from its current upswing should not be underestimated," the bank's China economics team, led by Ting Lu, state in a report to clients.

The Covid business cycle is far harder to anticipate than a typical business cycle.

"A downswing is generally triggered by a surge in new Covid cases, travel bans, lockdowns, closures of factories and shops, and disruptions to supply chains," the Nomura team explain.

"The economy falters as a result. At its trough, new cases slump thanks to restrictive lockdowns, with the government eager to lift lockdowns and stimulate the economy to avoid a deep recession. The economy then bottoms out. However, as mobility recovers and people drop their guard, new cases may suddenly surge again, and the government then rushes to re-impose lockdowns, causing the economy to contract again. The duration and severity of CBCs appear quite random due to the uncertain nature of Covid-19."

The Omicron variant is so subtly spread and infectious that it's unlikely even China, with the government's almost total control of every aspect of life, can stamp it out. Besides Shanghai and Xian, there are also current outbreaks in Anhui and Jiangsu provinces, major industrial centers to the north and west of Shanghai.

Cities such as Singapore, Seoul and Bangkok are proving increasingly popular as bases for executives looking to serve Asia. Both Hong Kong and China not only impose week-long quarantines for any international trip but also insist on strict testing regimens for returning travelers, leaving travelers on tenterhooks in the 48-hour window for them to record a negative test prior to departure.

I have a friend attempting to return from London to Hong Kong with her three daughters. Late last night, her London-conducted Covid test returned a positive result, even though the three children proved negative. Two other household members had already departed, negative results in hand, although one trying to fly to Japan was told he had taken the wrong kind of Covid procedure and must retest.

An hour of panicked replanning later, my friend received another email from the testing lab informing her that she should "ignore" the positive result, delivered at 11 pm, and that her test would be rerun the next day. That leaves her desperately wondering what the result will be today before her scheduled departure early Tuesday morning. Should she attempt another test? How was a mistaken positive result generated? What are the flight/hotel rules on teen daughters traveling alone?

It's notable that no one cares whether they actually have Covid or not. The only issue is whether they can post a negative Covid result to satisfy the authorities. And in Hong Kong, the authorities surely don't really care either - there were 2,992 Covid infections reported on Sunday in Hong Kong, more than 2,700 of them locally transmitted. The virus is already endemic, and doing the rounds. Quarantine, as a way of keeping the virus out, serves no purpose at all. Other than a political one.

Chinese President Xi Jinping has made the eradication of Covid a central platform in his attempt to win reelection this fall, to an unprecedented third term. His administration is therefore desperate to keep Covid case counts to a minimum in the runup. Xi will do whatever it takes to keep counts low, no matter the cost.

Christopher Wood, the global head of equity strategy at Jefferies, writes in his latest Greed & Fear newsletter that optimistic forecasts of China opening up mask reality. Any case number higher than zero presents an imminent risk that China will shut down any of its cities, and risk paralysis of the world's second-largest economy, in the name of Xi's political preservation.

"Meeting with investors in the U.K. this week, Greed & Fear forms the impression that many are of the view that China has relaxed Covid suppression without formally admitting it on the account of the collateral damage done to the economy," Wood states. "This is certainly a possibility. But the problem with this assumption is that Xi has remained publicly committed to Covid suppression. And he has a track record of meaning what he says."

For some citizens, it has been a shock to the system, quite literally, to see how much power the Chinese Communist Party can hold over their lives. Instances where authorities in provinces such as Henan have abused the red-yellow-green system of health codes on mobile phones to prevent demonstrations and curtail the movements of protestors have only served to deepen the mistrust.

The authorities have punished five officials in Henan's capital, Zhengzhou, for changing the codes of depositors in troubled rural banks after they began heading to the city to complain. With their health code newly showing red, the demonstrators were kicked out of the city, taken into quarantine and then sent back home, ostensibly on health grounds.

Likewise, homebuyers of an uncompleted residential project by Sunac China Holdings (SNCHY) and HK:1918 said their health codes suddenly turned red for no apparent reason after they went to Zhengzhou to report problems with the development. After filing their complaints and returning home, their phone codes turned red, preventing them from traveling again.

China was posting 100 new cases as recently as June 30, but that tally has quadrupled. It is a tiny number of new infections for a country of 1.4 billion, and government numbers reported out of China are often manipulated, but the direction is clear.

Covid's return eats at consumer confidence, with citizens never sure whether their home city is next to be locked down. A nascent home-sales rally in June has given way to pessimism once again. New-home sales in 30 major cities fell 43.7% in the first week of July, according to tracking by financial-data provider Wind, similar to the 48.0% fall in May, whereas a mid-June surge in residential sales saw the overall sales decline in June narrow to a 6.4% drop.

The Wind numbers fluctuate and have a bias toward the biggest cities. Only a few weeks ago, a recovery in Wind-tracked sales led to bullish forecasts that a property recovery was already starting. Those hopes are now undone.

Other numbers from the China Real Estate Information Corp. show that sales for the 100-largest developers in China plunged 50.8% in June in terms of volume. Such huge moves would have been shocking prior to the pandemic but have now become the norm.

Inflation remains modest in China since consumers are still managing their finances carefully. The Consumer Price Index rose to 2.5% in June, according to Monday's year-on-year data, up from 2.1% in May. Consumer prices may peak at a little over 3.0% in September, according to Nomura, off a relatively low base.

Producer prices have even started to slide. The PPI data released Monday show growth slowed from 6.4% to 6.1%, year on year. The Japanese investment bank predicts producer prices will also normalize toward 3.0% by the end of the year.

These signs of stability can be undone quickly if Covid rears its head. Macau has today begun a weeklong shuttering of its casinos, only the second time they have been closed since the start of the Wuhan Covid outbreak in late 2019. The first wave caused a closure for 15 days.

The casinos are the city's economic lifeblood. Standard & Poor's now forecasts that Macau's gaming revenue will only hit 20% to 30% of normal 2019 levels for this year, down from their original forecast of 30% to 40%. Next year's take from the tables will be 50% to 70% of normal, S&P predicts, instead of its previous 80% forecast.

The ratings agency therefore warns that there is higher downgrade risk for the major Macau casino operators: Las Vegas Sands (LVS) via its Sands China (SCHYY) and HK:1928 subsidiary, Melco Resorts (MLCO) and Wynn Resorts (WYNN) , via its Wynn Macau and (WYNMY) and HK:1128 subsidiary. MGM Resorts (MGM) and its MGM China Holdings (MCHVY) and HK:2282 subsidiary offset their Macau risk with a heavy dose of U.S. exposure but will also feel the pinch.

Investors will need to watch those Covid case counts closely in China for future guidance. Earnings forecasts are governed as much by epidemiologists as any insight gleaned from an analyst with Series 86 and 87 clearance.

At the time of publication, Alex Frew McMillan had no position in the securities mentioned.