Chinese equities continue to be volatile. In October, markets tumbled close to historically low valuations as headline news weighed on sentiment, including additional restrictions on chip exports by the US, increasingly strict pandemic controls ahead of the Communist Party Congress and a new leadership line-up consisting entirely of President Xi’s loyalists. Foreign investors may have had unrealistic expectations from the Congress precipitating a fire sale of overseas-listed Chinese shares which sent the MSCI China index down heavily, only for November to completely erase those and some earlier losses. Chinese equities have continued their recovery since
Macroeconomic indicators point to a slowdown in recovery. Purchasing Managers Indices contracted since October, and travel volume fell significantly during the National Day holiday compared to a year ago due to COVID controls. However, in an unexpected about-turn following rare public protests, COVID restrictions have now been eliminated and the direction is very clear: a full reopening scenario is upon us. A wave of infections will have a short-term impact on absenteeism and consumer spending, but this will clear eventually and barring new variants or other unexpected developments, the economy could be in full swing by the middle of 2023.
Mohamed El-Erian, Chairman of Gramercy and previously CEO of PIMCO, recently described the future for investors globally as the “bumpy road to Disneyland”. He described a picture of an excited father and son leaving for Disneyland but arriving all tired and exhausted after going through traffic, detours, and travel sickness. The excitement was totally beaten out of them by the time they eventually arrived.
This resonates with an investor in China over the last two years. There have been many bumps on the road, whether it is regulation, geopolitics or COVID lockdowns. It’s worth revisiting why one should travel to Disneyland – i.e. invest in Chinese equities - in the first place.
Why invest in China?
The Chinese equity market is the second largest market in the world after the USA. It is larger than Japan and Europe put together with thousands of companies, many of which are growing rapidly and operate in industries where China is dominant (like electric cars), but they are underrepresented in global market indices. Many hundreds remain after screening for ESG, growth and liquidity, again far more than anywhere else in the world apart from the USA.
These companies are either selling to the world’s largest population or are part of the supply chain of the world’s largest manufacturing base. China is responsible for manufacturing about 35% of the world’s electronic devices (as much as 70% for some categories), most of which are consumed within China. Even if the rest of the world stops manufacturing in China, it will continue to be a major production hub just to meet demand from domestic consumers.
The charts below show that if the USA really wants to stop selling semiconductors to China it would be a major problem for the global manufacturing of electronic devices.
GLOBAL SEMICONDUCTOR SALES BY GEOGRAPHIC AREA
Source: UN Comtrade; BCG x SIA: Strengthening the Global Semiconductor Supply Chain in an Uncertain Era, 2019
Then there is the sheer supply of talent and entrepreneurs that live in the world’s second largest economy. If we look at annual science, technology, engineering and mathematics (STEM) graduates we see that China has more than the next 6 countries combined.
Source: World Economic Forum, 2016
China is unique in having an organised economy with first world infrastructure, abundant talent, skills, and capital (both government and private finance) combined with the largest consumer population and a major manufacturing hub. That is why Chinese companies are so good at large scale engineering. For example, the Tesla Gigafactory Shanghai deal was signed in May 2018, construction was completed in ten months and the first car delivered in December 2019. It employs 2,000 people and can produce 750,000 cars annually - significantly more than any facility in the USA. That is almost impossible to achieve for most countries.
For an entrepreneur with a successful idea, they don’t have to leave China to become the world’s largest – to make it to the proverbial Disneyland. The domestic population is enough to ensure success. It is perhaps no surprise that China has the most unicorns (start-ups worth more than $1bn) in the world after the USA.
Source: McKinsey Global Institute, "China's Digital Economy: A Leading Global Force"
The bumpy road
The last two years have demonstrated almost every reason why an allocation to Chinese equities should be moderate whether it be on ESG grounds, geopolitical tensions or government interference in running the economy. The margin of safety required to invest in Chinese equities has increased as these risks have become apparent. But we argue little has changed the fundamentals on this road to Disneyland. China deserves an allocation, sized to reflect the risks. If not for these risks, the allocation would be significantly greater than to most developed countries.
The fear of these risks has led to periods of indiscriminate selling with crashing valuations of even the best companies. Many of these companies are amongst the best in the world at what they do and many of them are either already delivering strong earnings growth or are going to be the beneficiaries of pent-up demand from consumers coming out of COVID lockdowns.
This contrasts with US companies that are still trading at relatively higher valuations while facing earnings uncertainty due to rising inflation and tightening monetary conditions. Nor are these US companies insulated from the geopolitical risks in China: restrictions on them selling to or manufacturing in China will have significant consequences on their revenues. So, it is odd that their valuations do not reflect this while the valuations of Chinese companies clearly do!
Ultimately prices will reflect fundamentals and we believe that the recent recovery will continue although it may not be a very smooth ride yet on the way to Disneyland.
Lars Hagenbuch, Investment Product Specialist, RisCura.
