Chinese equities experienced a significant drawdown during 2022, falling by over 20% since January. While this is in sympathy with global markets (the S&P500 fell by 13%), Chinese stocks, particularly those listed in Hong Kong or via US ADRs, have fallen considerably.
Several domestic and external events have hit the market simultaneously and asset managers have struggled to deliver outperformance, leading to the question:
Does investing in China still make sense?
Sceptics and advocates have argued for or against investing in China. Regulatory changes, the Evergrande property company default, potential delisting of US ADRs of Chinese companies, geopolitical tensions and most recently COVID-19 lockdowns are all good reasons why Chinese equities have underperformed.
But our short answer is yes. This is the world’s second-largest stock market with over 5000 listed companies. Even after screening for robust ESG requirements, that still leaves many companies who are either global leaders in their niche or fast-growing brands amongst the largest population in the world.
China retains multiple growth drivers compared to a world faced with stagflation — yet other regions still show high equity valuations. However, future growth drivers are likely to be different than over the previous decade. As the Chinese economy matures, consumer demand shifts from quantity to quality added to new opportunities in the green economy and from localising of supply chains.
Chinese consumers are choosing to buy premium products from local companies. This is very different to say Russia or Brazil where growing affluence results in higher demand for global luxury brands. Some items made by Chinese brands now cost thousands of dollars. For example, the most premium retail bottle of Moutai (a Chinese liquor) can cost up to $25 000 and the most popular mid/large-size SUV sold last year was an electric model from Li Auto, a Chinese company, well ahead of VW or BMW.
However, recent share price falls did have valid reasons.
COVID-19 lockdowns
China has doubled down on its zero-COVID-19 policy to confront its worst wave since March 2020, leading to significant short-term economic costs. Lockdowns have been imposed in Shenzhen, Shanghai and other cities and have dampened consumption, disrupted supply chains and affected many businesses. China hasn’t had multiple COVID-19 waves like the rest of the world given its zero-tolerance policy; it does not yet have herd immunity and many vulnerable citizens are unvaccinated. To avoid a spike in deaths, lockdowns will continue for now and are likely to disrupt the economy.
The Chinese are experiencing what the world went through in March 2020 and this is reflected in the depressed valuations of Chinese companies. Looking back, the pain was temporary and there will be a recovery. March 2020 was a great time for investment in global equities.
Regulatory impact
Chinese policymakers deemed that reforms were needed to improve social stability and for the economy to grow more sustainably. Regulatory action creates unpredictable market movements, and for the unprepared and unskilled, a difficult environment. Deep insight and specialisation are required to invest in Chinese equities. Specialist Chinese equity managers, often locally based, avoided the full impact of the regulatory onslaught compared to more generalist global fund managers. But the regulatory storm, which caused much of the market decline, may be at an end. In March, Vice Premier Liu He addressed key market concerns and called for order and transparency in dealings with big tech firms. Alibaba’s share price rebounded by 65% showing the significance of this event.
In financial services, the direction of regulation has been positive for many years. Cross-border market access has improved, and foreign asset managers can now operate without a local joint venture which led to an influx of global managers into China. The ability to tap the second largest stock market in the world with thousands of companies and also sell their investment products to the world’s largest population are essential for any global fund manager and research offices have started springing up on the mainland.
How can investors coalesce around China’s priorities?
We see three clear themes:
· Green economy
China’s aim to reduce emissions is creating unprecedented opportunities in the production of electric vehicles and renewable energy. There are entire industries building electric vehicle components that are growing rapidly and some exist almost entirely in China. For example, China produces 90% of the world’s lithium iron phosphate batteries.
· Replacement of supply chains
A theme that will continue for many years is China’s desire to become self-sufficient. Geopolitical concerns – like watching sanctions applied to Russia over Ukraine – have accelerated the policy of inward capacity replacement and growth in industries like semi-conductors where a Chinese company will now prefer a local supplier over one in the USA.
· Common Prosperity
The government’s pursuit of increasing equality will create opportunities and further losers. There should be opportunities for smaller companies as larger ones are forced to end their monopolistic behaviour.
Bringing it all together
In summary, we believe China is investible. It has its risks although most are abating, valuations are depressed, and the Chinese government is beginning to provide stimulus at a time when the world is at risk of stagflation. Meanwhile, high-quality companies in China are growing rapidly with new growth drivers such as the green economy and inward-focused technology replacement.
Lars Hagenbuch, Consultant, RisCura
