Morgan Stanley has upgraded China’s property sector to “attractive,” even as worried investors are watching closely to see if debt-saddled Evergrande might default, and whether there will be contagion.

The U.S. investment bank said it believes that policy easing of the property sector looks likely to kick in, which will support Chinese real estate stocks.

“We believe the default risks and property market weakness have been largely priced into property stocks,” Elly Chen, equity analyst at the bank, said in a note dated Oct. 10. “Property stocks will react on policy easing, which looks more likely now.”

“There have been several defaults since 2020 and escalating risk for a major developer default in 2021,” Chen acknowledged. She wrote that this “adjustment process” of reducing debt and policies to “manage system excesses” will likely continue for the next six to 12 months.

“However, property stocks are pricing in part of these risks, and we think systemic risk is manageable,” Chen said.

China’s property developers have grown rapidly following years of excessive debt, prompting authorities to roll out the “three red lines” policy last year. That policy places a limit on debt in relation to a firm’s cash flows, assets and capital levels.

Things came to a head after the policy started to rein in developers.

The world’s most indebted developer, Evergrande, warned twice last month it could default. It has missed interest payments on five offshore bonds so far, that were due in September and October.

Ratings agencies have also downgraded other Chinese property developers on tight liquidity and default risks.

Policy ‘inflection point’ approaching

But Morgan Stanley said a “policy inflection point is approaching.”

The analysts said there may be “potential upcoming easing measures,” as policymakers are expected to further ease mortgage quotas, as they have been trying to boost bank loans.

Home purchases have slowed this year, as Chinese cities implemented curbs including home purchase restrictions.

“Policy is the most important leading indicator for property stocks,” Chen said.

Residential property investment accounts for 6.5% of China’s gross domestic product, while property-related services account for a further 7.3%, according to Morgan Stanley. A 10% slowdown in residential property activity could drag down GDP growth by around 1%, the bank said.

“Further spillover could take the form of a negative wealth effect, dampening private consumption,” Chen said, adding that as a result, policymakers will likely provide “meaningful” easing to stabilize the property sector and support the economy.

Furthermore, most developers are on track to meet the “three red lines” criterion by the end of 2022, according to Morgan Stanley. The three red lines place a limit on debt in relation to a firm’s cash flows, assets and capital levels.

In the first half of 2021, 16 of 26 developers that the bank covers met the full criteria of the three red lines policy, while nine met two of the three criteria. Only one failed to meet all three criteria of that policy, the bank said.

Morgan Stanley’s top picks

Morgan Stanley has upgraded the China property sector to “attractive” in view of attractive valuation and more potential supportive measures aimed at boosting the real estate sector.

It says it prefers companies with strong earnings visibility, strong execution track records, and “robust” balance sheets.

The bank’s top picks are China Poly Group, CR Land, Longfor and Sunac.