China: what next?
Ben Sheehan, Senior Investment Specialist, Asian Equities
Devan Kaloo, Global Head of Equities
Is this the end of capitalism in China?
For us, no. But some people feel differently. China has underperformed global and emerging markets this year. A blizzard of regulatory measures has created investor uncertainty and in some cases challenged business models in areas such as ecommerce, education, healthcare and the property sector. The government is trying to address inequality. Since initiating market reforms in 1979, China has one of the fastest growing economies in history. But inequality has skyrocketed. Under the banner of common prosperity, the government wants to share gains among people by tackling anti-competitive practices, promoting labour interests and reinforcing the role of state in public services. At worst it represents a new brand of populism; at best it represents the next leg of China’s growth. It’s hard to argue China is about to give up on the success it has enjoyed over the last four decades through use of market principles to drive growth. I think it’s right the government is looking to tackle inequality. In recent times, China has had periodic bouts of regulatory uncertainty to tackle issues like corruption or the shadow banking system. In the short term it can be disruptive, longer term these have been sound, rationale actions.
The private sector remains extremely important to China’s future. It’s the nation’s largest employer and has driven innovation and growth. So the idea that China is stepping back from capitalism is far-fetched. Innovation is a priority in the 14th 5-year plan as China looks to move up the value chain to advanced-economy status. It requires a balanced approach: over-regulate and throttle innovation; under-regulate and create uncompetitive monopolies that also throttle innovation. So this is not the end of capitalism in China. Potentially it represents the next leg of growth and we should look to see where the opportunities are.
Does this change your investment thesis and how you invest in China?
Not really. We need to understand the headwinds facing China’s markets today. Firstly, there’s regulatory uncertainty. There’s also financial tightening – whether to control debt or speculative activity. In addition you have the impact of Covid, with lockdowns having impacted some domestic consumption companies. These are the things China is working through now. But if we step back and look at the long-term thesis for China, we see a country where companies have significant opportunities to make money. Foremost, we must ensure our companies can adapt to the emerging regulatory framework, stay on the right side of government policy and continue to deliver on government objectives such as common prosperity. There are also areas the government is looking to promote where we see opportunities, such as digital innovation, green technology, affordable healthcare and improving livelihoods. We think this can drive domestic consumption. So how we think about China hasn’t really changed. We need to be cognisant of government policy, and ensure companies adapt to changes or benefit from tailwinds. Strong growth and rising consumption are the themes we continue to focus on and find opportunities in.
Have you changed your portfolios on the back of changes in China?
Not a lot. Underpinning our exposure to China is our longer-term view about the rise of domestic consumption. We express this through exposure to high-quality companies well placed to benefit from the rise of the consumer and to meet government policy objectives such as common prosperity and improving people’s livelihoods.
Is China higher or lower risk now?
It depends on your starting point. In recent years we have seen global thematic-type investors looking to capitalise on the rise of ecommerce in China. Many may find it difficult to understand why Chinese regulators might look to tackle anti-competitive practices and safeguard labour. As a result, the recent regulatory push would have come as a surprise. So for these investors, perhaps risk has gone up. But if you have invested in China for years, regulatory action comes as less of a surprise. Consequently I don’t think China is significantly more risky today than it was 15 years ago. There’s great value in some sectors now. Our preference is for domestic names aligned to government policies where we see significant growth. You need to be mindful of geopolitical and regulatory issues and of the ability of companies to grow. In that regard things perhaps haven’t changed at all.
Will common prosperity policies boost consumer stocks? If so, why are they still lagging?
Ultimately, they will do. Part of the aim of common prosperity is to improve the livelihoods of individuals, so limiting expenses such as education, housing and healthcare is important. In theory, that could free up income for people to spend on other things. In addition, if wealth is distributed more equitably, segments of the population will benefit and potentially consume more. We think the underpinnings of common prosperity will result in increased consumption. It also fits in with the government’s goal of creating a more domestically orientated economy. In terms of why stocks are lagging, it’s a function of earnings. Aside from regulation, markets have been impacted by financial tightening and lockdowns due to the Delta variant. That has had an impact on underlying company earnings. But we see this as transitory. Ultimately, we believe many of these issues will fade away. As a consequence, we see the opportunity for long-term appreciation in some domestic names.
Who will the winners be and where do you see opportunities as the regulatory framework evolves?
The government wants to increase localisation and improve the value-add of technology developed domestically, in industries from semi-conductors to technology hardware to electric vehicles. These sectors are aligned. There’s also a green revolution going on in China. With the government committed to net-zero carbon emissions by 2060, there are significant investment opportunities from overhaul of the utilities sector to companies providing renewable inputs. We also see clear consumption patterns and trends for domestic brands to improve. Potentially, stocks and stock markets could benefit from future financial easing. One area where we see headwinds is the property market. The government has targeted the sector to safeguard affordable housing. If property companies can adapt, valuations look interesting. The government also aims to make healthcare affordable. There are areas it is pushing around research, development and the manufacture of new drugs which will offer opportunities.
Is common prosperity compatible with premiumisation and stocks such as Kweichow Moutai?
At first glance it appears not. But when you think about it in the context of people having more disposable income and the government’s desire to develop local brands to represent China domestically and internationally, then it’s very much about premuimisation. As a result, we believe companies such as high-end spirits-producer Moutai offer opportunities. Remember, Moutai does a lot of social good too. It’s a big employer and tax payer in some of China’s poorest areas and operates in an industry with lots of competition. The thing for investors to recognise is that it’s a concern if companies charge high prices due to monopolistic or anti-competitive practices. If people have options but choose to pay high prices because of a perception of brand or value, that’s ok.
What are your observations on the evolution of ESG in China, given you are a long-time investor?
It has improved significantly in the 20+ years I’ve been covering China and emerging markets. Pretty much every company in China is aware of ESG. Regulators also understand the importance of moving these things forward. So there has been significant improvement. It’s up to us as active managers and company shareholders to drive continued take-up. When we look at ESG analysis by external parties, more often than not the reason Chinese companies get rated poorly is because they don’t disclose the information or provide nicely written reports. It’s not because they have no interest in these issues. That’s very important as it potentially represents an investment opportunity.
Do you think regulatory risks will affect private or state-owned companies more in future?
The perception will be it impacts the private sector more. Recent regulatory moves have challenged the business models of education and ecommerce companies in the private sector, for example. But state-owned enterprises also need to abide by common prosperity. Potentially banks may need to change the way they lend money, by supporting more SMEs for instance. You could see state-owned property firms provide more affordable housing. So it affects everyone. But from an external public perception, it’s private companies in the cross-hairs.
Are we seeing the majority of regulatory announcements now or do you anticipate more to come?
Historically, China has been quick to mobilise resources to identify and tackle issues the government has prioritised. We anticipate continued regulatory measures to achieve common prosperity. Underlying that is a desire for stable economic growth and innovation to move China towards advanced economic status. That will require involvement of the private sector and capital markets. Investors should anchor themselves in that rather than focus on the news flow.
Should investors be worried about the potential for delisting ADRs?
If the US and China do not come to an agreement on auditing US-listed Chinese companies, then yes.. The Chinese government is keen to see more companies list within the Chinese sphere of influence. Many companies have dual listings and are simply shifting their primary listing from the US to Hong Kong. This transition to Hong Kong or direct into China will continue. Where we have a choice, we prefer the Hong Kong listing of Chinese ADRs as it mitigates geopolitical risk and over above this Hong Kong also has a robust legal framework that adds to investor confidence. We are less concerned about the ADR issue, though it does limit options for Chinese companies to raise new money, which means China will need to ensure that it is attractive and possible for companies to raise money elsewhere, like Hong Kong
What probability would you assign to a major financial risk event in China in future?
Relatively low. China has seen a huge increase in debt over the last 20 years, effectively since the global financial crisis. A lot of that has found its way into the property market and state-owned companies. There’s concern about the misallocation of capital via the mis-pricing of that debt. There has been a gradual attempt to allow the market to price risk and make better capital allocation decisions. As a result, you have recently seen reactions to credit concerns occurring in the bond market, which is as it should be. We expect to see the continued evolution of China’s debt market in terms of the pricing of capital. Of course, the government also wants to avoid risks to the broader financial system. In terms of managing systemic risk, I think the way the government is approaching it is quite prudent.
What are the knock-on effects of China’s softening economic growth? Does that impact the investment case for China?
China seems to be leading the world in a number of ways. It was first into Covid, first to recover and now seems to be the first to see its economy slow as a result of financial tightening and Covid/Delta resurgence . We also expect large Western economies to see a downturn in the economic cycle, with the potential withdrawal of monetary stimuli and Covid. The next stage for China is that it will start easing again, making more capital available in the economy and leading to increased lending. As a result, we would expect to see China’s economy pick up. That could happen as other parts of the world start slowing down as they move past stimulus and feel the impact of the Delta variant. So we are relatively optimistic about China’s economic outlook. But we need to stress that China is more concerned about the quality of growth today than at any time in the past. We don't expect the gangbuster growth levels we have seen in the past. We expect to see a change in the direction of China’s growth, from one of a slowdown to one of acceleration.
Given the pullback in consumer stocks, is now as a buying opportunity?
Yes, we see opportunities to add to existing positions, particularly for domestic A-share names. Ecommerce is the big one for foreigners, but I don’t think we’re quite through the woods yet in terms of regulatory pressures and their impact on businesses. I would be a little gun-shy of adding to ecommerce positions now. That said, they represent great value. Ultimately, as and when some clarity comes through with regard to business models the government is comfortable with, we expect these companies to do very well. It’s an area we will focus on when the time is right to start building up positions.Company selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.