Several forces have pushed Chinese stocks lower in 2021, with the authority’s heightened regulatory focus a key headwind.
Wren Sterling asked Paul Danis, Brewin Dolphin’s Head of Asset Allocation, to explain the implications for investors.
What’s going on in China?
The Chinese authorities shocked markets last autumn by pulling the IPO of Ant Group a mere two days before the event was due to take place. It was set to raise $37bn, which would have made the listing the largest ever by a wide margin. Since then, there has been a steady stream of announcements from Beijing which has made clear the authorities will take an increasingly hands-on approach to regulating companies and managing the economy. Chinese president Xi Jingping unveiled his populist “common prosperity” plan, which is designed to reduce social / economic imbalances. In a nutshell, the plan entails beefing up public services and the safety net, reducing inequality and expanding the middle class.
What are the implications for the Chinese economy?
Most investors buy in to the view that the Chinese economy will continue to expand at a significantly faster pace than most other countries for the foreseeable future. But it’s debatable whether Xi’s common prosperity drive is going to help or hinder China’s already superior structural economic growth trajectory. On the one hand, less inequality and a bigger social safety net will likely result in a lower aggregate household saving rate in China (which at around 30% is currently very high). That means less saving and more spending which should support growth. On the other hand, common prosperity policies and greater regulation could weigh on private companies’ willingness to invest.
Since 1995, the Chinese economy has grown over 2000%, while Chinese equities have provided a USD total return of only 124%
Isn’t a positive economic outlook good news for China-listed equities?
Since 1995, the Chinese economy has grown over 2000%, while Chinese equities have provided a USD total return of only 124% (as of September 2021). The regulatory pivot by the authorities doesn’t inspire confidence that the relationship between economic growth in China and equity performance is about to change. At any rate, the greater regulation and the higher wages and taxes that could result from Xi’s common prosperity drive should probably be considered headwinds for the Chinese corporate sector over the medium term.
How has the Chinese stock market reacted?
Chinese equities began to sell off sharply in February this year. The peak coincided with a realisation among investors that the authorities’ regulation drive was more than just about reining in Ant and its founder Jack Ma, who had been critical of government policy. The MSCI China index put in a tentative bottom in August after a peak to trough decline of 32% (in USD total return terms). This was bigger than the 22% loss the index made at the height of the Covid-19 crisis, but less than the 78% loss that Chinese equities made during the 1997 Asian financial crisis.
Are some areas of the Chinese market affected more than others?
The tech-like internet companies (such as Alibaba and Tencent) have been hard hit. This reflects the authorities’ drive to correct what they view as anti-competitive practices, limit time playing video games for under-18s, and address privacy concerns, among other things. Another factor at play is that many of the hardest hit Chinese companies are listed on US exchanges. This hasn’t been the cause of their poor performance, but there is some concern that these might ultimately need to be delisted from the US and re-listed on one of the Chinese bourses. Uncertainty remains with regards to how this will ultimately unfold. A forced US delisting may weigh on share prices around the time when it happens. But this probably isn’t the factor that investors need to be most concerned about.
China’s authorities are taking greater control, but the country is not going ‘full Soviet’. It’s still going to be an extremely innovative and entrepreneurial place.
Don’t lower valuations provide an attractive buying opportunity?
The MSCI China equity index is trading at a 27% discount to the global market on 12-month forward price to earnings ratio, which is bigger than its historical average discount of 18%. This is certainly a much more attractive multiple than Chinese equities were trading on earlier this year. However, it’s not clear if it is low enough given the profit headwinds many of China’s most valuable companies are now facing due to the new regulatory reality. Chinese equities have been cheaper before: they traded on a 42% discount following the 2015 sell off. Meanwhile, Chinese profit margins are high relative to history. After enjoying an almost straight-line expansion since 2013, margins are now vulnerable to some compression.
Should I avoid Chinese equities entirely then?
China is not one of our currently favoured equity benchmarks. However, we believe it makes sense to have some exposure. While there’s room for Chinese profit margins to decline, there likely won’t be a collapse. China’s authorities are taking greater control, but the country is not going ‘full Soviet’. It’s still going to be an extremely innovative and entrepreneurial place.
The Warren Buffet approach to investing is to be “fearful when others are greedy, and greedy when others are fearful”. The dominant market emotion toward China at present is fear. Mid last month, ‘China’s attack on tech’ made it onto the cover of The Economist magazine, widely thought of as being a contrarian indicator. Personal finance writers are also raising doubts about investing in China, which perhaps indicates the risks are widely appreciated. The negativity toward China can be observed in the fund flow data as well. Global equity funds have cut their exposure to China and Hong Kong, and there’s been a surge in emerging market flows going into exchange traded funds (ETFs) that exclude China.
There are also cyclical reasons to not want to become overly bearish toward China at this juncture. Chinese economic growth slowed sharply this summer due to a Covid-19 wave, which now looks to have been brought under control. In addition, after tightening fiscal and credit policy in the first half of this year, signs have emerged that the authorities are shifting to a more supportive stance. All this implies a cyclical growth rebound in China, which should support the equity market.
Brewin Dolphin is one of Wren Sterling’s investment management partners.
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