Expect Chinese stocks to rally hard now that Beijing has set a 'clear path' to reopening, Morgan Stanley says

• Morgan Stanley upgraded its outlook for China equities and expects a move toward ending zero-COVID controls to boost stocks.
• Hong Kong's Hang Seng index could rally 13% from its current level by the end of 2023, strategists said.

China looks like a tempting investing option again with policymakers moving toward an economic reopening, according to Morgan Stanley.

The easing of zero-COVID controls that started earlier this month will likely boost earnings, the US bank said, upgrading Chinese stocks to an 'overweight' rating against emerging markets for the first time since the pandemic started ravaging the global economy in March 2020.

"Multiple positive developments alongside a clear path set toward reopening warrant an upgrade and index target increases for China," a team of strategists led by Laura Wang wrote in a research note published Sunday.

Cities across China including Shanghai and Shenzhen eased their Covid-19 testing requirements last week, which many analysts believe signals that Beijing is shifting toward ending its harsh "zero-COVID" pandemic policies in favor of an economic reopening.

That could lift the Hong Kong Hang Seng index 13% and lead to MSCI's China Index jumping 14% as a revival in demand leads to companies posting stronger earnings, according to Morgan Stanley.

"Our base case is that we are at the beginning of a multi-quarter recovery in earnings revisions and valuations with decent ROE improvement," the strategists said, referring to the return on equity measure of profitability.

But that doesn't mean investors should pile into Chinese stocks right now — with the impact of the economic reopening likely to lag until the second quarter of next year, according to Morgan Stanley.

"The path will be bumpy," Wang's team said.

"Pressure on earnings should continue through the first quarter of 2023," the strategists added. "Market volatility could stay high owing to wide swings in sentiment between over-optimism for a fast reopening and at times rapid disappointment regarding a seemingly slow and zig-zagging move towards a Covid-zero exit."

Investors should also keep an eye on relations between Beijing and Washington, according to Morgan Stanley – with US secretary of state Anthony Blinken reportedly planning to visit China next year.

Official confirmation of that trip would likely further lift the market's view on Chinese equities, strategists said.

Read more: US futures rise and Hong Kong stocks jump 5% after China's vaccination move boosts hopes for a zero-COVID pivot