Tightening monetary policy and a regulatory clampdown meant Chinese equities had a year to forget in 2021. Are we in for more of the same?
Long used to stellar growth and returns, 2021 was a year which investors in China would rather forget. Worries over the build-up of debt in real estate companies such as Evergrande spooked investors, while big tech companies suffered a regulatory clampdown, as did the online education sector. As a result, the whole market fell, leaving investors wondering whether they were best out of the country, or if this represents a buying opportunity.
“Last year was a pretty awful year for China,” says Mike Kerley, portfolio manager, Pacific equities, at Janus Henderson Investors. “So bad, in fact, that the 49 per cent differential in the performance of the MSCI China versus the S&P 500 is the biggest disparity in the history of those indices.”
But the year did not start off that badly, with the country receiving plaudits for the way in which it was coping with the Covid pandemic. Indeed that was part of the problem, as China did not need the same kind of quantitative easing and central bank support that much of the world did. So the Chinese market did not see the same levels of excess liquidity as others, which drove up asset prices elsewhere.
But 2021 was also the year in which Beijing chose to make some “pretty astounding” changes, he says, with the push towards ‘common prosperity’ and a host of new regulations.
“I think most of us would applaud anybody trying to reduce the wealth gap, to address the huge disparity between the wealthiest and the poorest people,” says Mr Kerley, but the way in which China went about this was “probably a little clumsy”, he says. China also has a demographic issue long term, with a working age population that will shrink considerably from 2025 onwards. And one of the reasons people are not having as many children as they once did, despite the removal of the one child policy, is the cost of bringing up children.
“That is why we saw a lot of measures focused on education, healthcare and property,” says Mr Kerley. And these measures have proved popular domestically, he says, pointing to an Edelman survey which showed the trust rating among Chinese people in their government actually rose last year to reach 91 per cent, the highest level seen in a decade.
Shock to the system
The policies may be proving popular among the Chinese population, but they have proved massively disruptive for investors. Not everyone was surprised by the moves, says Alice Wang, who manages the Bamboo and China funds at Quaero Capital. She had actually moved out of technology stocks by the end of 2020, for example, as “there were already signs on the horizon”, but she did not expect just how hard the hit would be to investor confidence and sentiment.
“I definitely didn’t anticipate the way that it would drag the entire market down,” says Ms Wang. “I felt the market would be able to differentiate between sector specific or even company’s specific downside, but actually, it turned out to be a full market wide de-grossing.”
Yet now she believes there are opportunities to be found, with for example, many of the technology companies, some of them the biggest companies in China, looking “very undervalued”. And with the Chinese central bank likely to be loosening this year, that should give these names further support. She likes tech names which are “essential”, she explains, building infrastructure rather than media players or gaming.
Another big call for Quaero is healthcare. “The older generation in China are savers, but healthcare is their consumption. You want to be in the leading healthcare players that can generate amazing drugs and cater to that need.”
China is developing drugs which are much cheaper than the US ones, but which rival their efficacy, she says, and have a huge potential market both within the country and overseas. “Healthcare stocks suffered last year, which was challenging for our portfolio, but if you take a long term view, I would say these are some of the best buying opportunities, even better than tech, because healthcare ultimately does have long-term government support.”
The dust is now settling after an abrupt and unexpected period of increased regulation, says Edward Evans, portfolio manager, emerging market equities at Ashmore.
“Last year and into 2022, the focus of the Chinese authorities has been a shift to greater clarity and specifying what those early announcements meant, which provides greater structure to how one can consider the possible ramifications of that increased regulation,”he says.
Investors are also appreciating this is not a uniquely Chinese phenomenon, he says. South Korea has increased regulation of its tech sector, as has the US, so it may be the case that China is ahead of the game and now has much of the necessary regulatory framework in place.
In 2021, the Chinese government displayed willingness to trade off sharp economic growth for quality and sustainable growth. These policy shifts, coming on top of a restrictive monetary and fiscal stance, created market volatility as investors reset their expectations, says Michael Lai, portfolio manager, China Equities, at Franklin Templeton. But industry participants and investors have now recognised the government’s strategic aims and are adapting to the new regulatory frameworks, which shapes his more optimistic outlook on Chinese equities.
For example, internet companies have been adjusting their business models in light of the new socioeconomic order, which has weighed on their earnings growth and stock valuations, but Mr Lai is hopeful “they can resume their earnings momentum when the regulatory dust settles and their new business models take shape, perhaps toward the second half of 2022”.
In healthcare meanwhile, investors worried about a regulatory overhaul overlook the major reforms officials have already introduced in the past few years to improve drug affordability and quality for an ageing population, he says.
“The National Reimbursement Drug List and Volume-Based Procurement programme, for example, have helped lower drug prices. The government is also encouraging development of best-in-class treatments in China, and we have seen local biotechnology firms succeed with innovative oncology drugs that have secured regulatory approvals and licensing deals in the West.”
Although Mr Lai believes the most extensive policy changes are largely behind us, it is not possible to rule out further crackdowns completely. “Industries that begin to see market concentration risk, excessive capital inflows or other imbalances are likely to draw regulators’ attention. This highlights the realities of investing in China, a market that we think is more policy-driven than economy-driven,” he adds.
Chinese policy-makers were clearly intent on reducing the economy’s dependence on investment in the real estate sector and to gear the economy towards consumption of more domestic goods and services, but this clearly did not pan out as planned, says Aneeka Gupta, director of macroeconomic research at WisdomTree.
“By the end of 2021, Chinese policy-makers finally threw in the towel and mobilised forces to re-stimulate the economy,” she says, and the economic restructuring will now be a more long-term project than originally planned. “It is amply evident that Chinese authorities have a pro-growth agenda in 2022 – the Year of the Tiger – that has given way to renewed policy easing and are willing to utilise the tools when needed.”
China is likely to be the one major economy loosening monetary policy this year, which will provide a tailwind, while inflation is likely to prove less of a headache than in other markets, giving the central bank more flexibility.
At the end of December 2021, the MSCI China Index was trading at a 38 per cent discount to the MSCI World based on forward price to earnings ratio, points out Ms Gupta. “Evidently Chinese equities boast attractive valuations versus the rest of the world and as monetary conditions become more conducive and regulatory hurdles subside, we expect Chinese equities to play catch up.”
Opening up
Yet much depends on Covid. The emergence of more virulent strains of the virus are always a concern, but while much of the world is beginning to gradually open up their economies, China remains wedded to its zero-Covid strategy. While this proved highly effective in the early stages of the pandemic, many are now questioning its continued implementation.
“I think zero-Covid has been a disaster for any kind of services because they all had to close up shop, while infrastructure spending has been cut because the government needs that money to combat the next outbreak of the virus,” says Quaero’s Ms Wang.
But she believes it will be hard for the government to abandon the policy because they have made it such a “pillar” of their strategy. “The economy may be suffering, but no one is dying. And the Chinese people buy it because they’ve been fed so much fear about Covid.”
Zero-Covid looks set to remain, agrees Mr Kerley at Janus Henderson, at least for a while, though he does admit that if the country is able to successfully develop their own mRNA vaccine then that could change things, especially if it was rolled out in conjunction with Western vaccines, which have proved more effective than domestically-produced variants up until now.
One further thing to consider when investing in the country is the geopolitical situation, says Luca Paolini, chief strategist at Pictet Asset Management. For some time attention has been fixed on China-US tensions, but eyes are now focused on another part of the world.
Explaining how Pictet has recently upgraded Chinese stocks from neutral to positive, he says: “Chinese stocks could work as an effective hedge if the Russia-Ukraine crisis escalates into a full-blown military conflict.”
Going green
China is the world’s largest carbon emitter, but the country’s pledge to achieve net zero carbon by 2060 will bring tremendous investment opportunities in sustainable companies, says Victoria Mio, lead portfolio manager at Fidelity International.
In early February, Fidelity announced the launch of a sustainable China A-Shares fund that will look to access China’s key emitting sectors which are transiting toward de-carbonisation. “We identify critical technologies across respective sectors such as efficiency improvement and waste management, increasing uptake of renewable energy as well as rising electric vehicle (EV) penetration and the development of battery technology,” she says.
The fund will also look to find the “transition enablers” which will empower the transition, for example, in technology, digitalisation and cloud services can help reduce society’s carbon footprint, while in financials, the promotion of green financing and carbon trading will help accelerate China’s growing green economy.
China’s push for quality economic development and a better living environment has helped the renewable energy and electric vehicle (EV) industries, says Michael Lai, portfolio manager, China equities, at Franklin Templeton.
“China’s EV industry has crossed a tipping point, where consumers’ growing acceptance of EVs as their primary vehicles suggests it may not need a lot more government support from here. In fact, we believe China may find it favourable to foster national champions in the EV and renewable energy industries that could go on to become global leaders.”
VIEW FROM MORNINGSTAR: Regulatory blitz leaves its mark
The Chinese equity market went through a challenging 2021. The MSCI China Index was one of the poorest performing major markets globally, ending the year with a 21.72 per cent loss and lagged the MSCI ACWI Index’s 18.54 per cent. In addition to a string of regulatory actions on various sectors, we also witnessed a style rotation from growth to value.
The previously well-loved, growth sectors such as internet and education suffered the most from the regulatory crackdown. Within the internet sector, the anti-trust policies have affected multiple dominant players: Alibaba was fined $2.8bn for monopolistic practices after its failed IPO of Ant Financial; Tencent was banned from releasing new apps and updates; and Meituan, the food delivery giant was also fined for abusing its market position.
The China equity portfolio managers we spoke with had differing reactions. Some held a conservative view, expressing concerns that stricter regulations would slow the companies’ growth trajectory and promote increased competition by giving opportunities to the lower tier players to gain market share.
Conversely, other managers believed this created a good opportunity to buy China tech firms cheaply. They argued that e-commerce and other internet-related facilities comprise an integrated service that is here to stay, and while growth rates may not be as high as before, it continues to offer long-term opportunities.
The education sector is one the bulk of managers we spoke to would avoid as a result of the magnitude of the regulatory crackdown. Although the sector was previously well loved, the Chinese government rolled out new regulations that require K-12 classes, the most profitable segment for after-school tutors, be run in a non-profit manner, which undermines these education names’ business cases.
In contrast, electric vehicle-related companies and solar firms such as CATL and LONGi Green Energy Technology enjoyed a strong rally in 2021, benefiting from China’s supportive industry policies serving its goal of reaching carbon neutrality in 2060. We again saw diverging views from portfolio managers. While some believed this is a long-term, structural growth story in China and continued to uphold their positions, others were deterred by high valuations as well as the intensified competition landscape.
On the value end of the spectrum, Chinese banks have generally done well and some portfolio managers liked the large state-owned banks for their consistent high dividend payout ratio in a low yielding environment. That said, the more quality-focused managers have typically shied away from the sector given the large banks are often used as policy tools and not necessarily managed in the best interest of minority shareholders.
While the China equity market experienced a tumultuous 2021, it continues to grow its importance in the global investing arena with increasing weightings in major equity indices. As a deep and diverse market, it offers plenty of long-term growth and alpha opportunities. We believe mutual funds are appealing long-term tools for investors seeking to participate in China’s structural growth trends. It is important for investors to pick funds backed by capable portfolio managers, stable and well-resourced supporting teams, and a tried-and-tested investment process.
Claire Liang, senior manager research analyst, Morningstar
