After a disappointing 2022, some tailwinds will drive a recovery in retail sales and production in the Chinese auto sector in 2023, Goldman Sachs said.

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Goldman Sachs raised its retail sales estimates for the Chinese auto sector after China unexpectedly began a full relaxation of Covid controls late last month.

The Wall Street bank raised their forecast for 2023 retail sales of passenger cars in China to 20.5 million units from 19 million units previously, according to a research note sent to investors by analyst Fei Fang's team on Monday.

That implies flat year-on-year growth, driven by the lifting of Covid controls in China, the subsequent reopening of dealerships and shopping mall showrooms, and the stabilization of income expectations for certain buyer segments, according to the note.

"We raise our passenger car industry estimates for 2023E to reflect China's faster-than-expected reopening supported by the potential continuation of auto stimulus policies (e.g. purchase tax reduction), fewer-than-expected prebuys in 2022 with retail dampened by the pandemic and dealership lockdowns in 4Q, and BYD-led EV export growth into Europe, ASEAN, Japan, and the Latin American markets," the note reads.

After a disappointing 2022, these tailwinds will drive a recovery in retail and production in the Chinese industry in 2023, Goldman Sachs said.

In addition, a key question is whether Chinese regulators will maintain auto stimulus at strong levels as a policy tool to boost domestic demand, the note said.

The revision is in line with an update to Goldman Sachs economists' GDP growth forecast for China, where the bank expects a volatile path of recovery:

The outbreak to disrupt 1Q auto retail, followed by strong 2Q yoy growth off the lock-downs' low base this time last year, then subdued 3Q yoy due to the stimulus-led high base last year, and finally a positive 4Q yoy.

Goldman believes most automakers and suppliers will respond to this environment cautiously, setting product prices conservatively and controlling costs tightly, while maintaining sales and marketing intensity to defend market share.

In this context, Goldman Sachs highlights investment ideas involving three companies on their Conviction List -- BYD (OTCMKTS: BYDDY), Li Auto (NASDAQ: LI), and Zhongsheng Group.

BYD seeks leadership in auto manufacturing and battery manufacturing and it is expected to gain share in the large and growing Chinese market, according to Goldman Sachs.

The bank expects pricing growth to accelerate as BYD focuses its lineup on high-average sales price models, primarily those priced above RMB 200,000.

The "fashion risk" of BYD's car designs is reduced, as evidenced by its steady performance on the EV charts in recent years, Goldman Sachs said.

For Li Auto, Goldman believes the company is differentiating itself from the broader Chinese auto manufacturing industry by envisioning and creating compelling EV consumer experiences and demonstrating a willingness to take risks and innovative actions with unconventional technologies.

"We believe the success of Li ONE illustrates the company's understanding of consumer needs, operational capability as well as brand establishment, and it is leveraging these to its next generation products of EREV/BEV models with evolving autonomous driving technologies. We see risk-reward skewed to the upside," Goldman Sachs said.

Zhongsheng is the largest listed dealer of Mercedes-Benz, Lexus and Toyota in China, operating 412 stores, mostly in first-tier cities, by the end of 2021.

Goldman believes Zhongsheng is poised to see business acceleration as each of its core brands looks set to drive milestone product launches and network expansion through its market leadership position.

The bank also mentioned Nio (NYSE: NIO) in their note, saying that with the launch of the new EC7 model, they are raising their sales forecast for the company by 4.2 percent in 2023.

"However, we believe bumpy sales volume in different quarters and the decline of national subsidy will have a negative impact on Nio's profitability," Goldman Sachs wrote.