China: looking beyond the turbulence

It has been a turbulent few months for investors in Chinese equities. After its July centennial, the Chinese Communist Party rolled out a raft of regulations. A dive in Chinese names began with an investigation into Didi, following its hasty initial public offering.

Panic selling peaked and the Chinese tutoring industry was forced to go non-profit. While many expected stricter regulation in this area, few anticipated a controlled ban through introduction of a not-for-profit model. This ‘black swan’ event spread panic across internet, healthcare, and consumer discretionary sectors, as investors feared they could be the next target for clampdowns.

In August, President Xi’s emphasis on “wealth redistribution for common prosperity” drove rotation away from policy headwind industries, such as internet, luxury and real estate, towards tailwind sectors like the electric vehicle value chain, semiconductor technology and high-end manufacturing.

Compounding equity market pressures, emphasis moved to the $60trn Chinese property market in September as Evergrande’s potential debt default raised concerns about systemic risk. When things looked like they could not get any worse, the end of the quarter saw large-scale power outages in more than half of Chinese provinces, further dampening the growth outlook.

Many of these policies had already been proposed, but the duration, intensity, scope, and velocity have come as a shock. The unpredictable nature of regulation spooked many global investors, as funds moved underweight China in the third quarter, with Chinese equities underperforming their US counterparts by circa 30% despite a higher growth rate.

The conundrum – grow the pie or split it?

From a Chinese internal standpoint, 13% growth in the first half of 2021 leaves plenty of scope for a slower second half with an annual target of 6%. The pressing task will be to keep growth going in 2022.

China’s large population is slowing and ageing, having once fuelled rapid growth. While annual population growth slowed to 0.5%, the 2020 census suggests the elderly dependency ratio doubled in the past decade – adding a further burden on China’s in-deficit pension system. The regulator reacted by abolishing its one-child policy, yet restriction removal is not enough to incentivise more births.

Consequently, the regulator targeted three sectors – education, housing and healthcare. These are deemed the heaviest burdens for household income and wellbeing, and therefore the biggest obstacles to births. Hence we witnessed the private tutoring industry crackdown, paired with a desire to curb rising house prices, which locks up more than 60% of Chinese household wealth.

The cooldown in property sales, paired with a restriction on developer leverage, foreshadowed Evergrande. Last, the authorities levelled up national drug procurement, along with healthcare services pricing reform, which shocked the private hospital industry.

Facing a population conundrum and growth bottleneck, authorities have inevitably refocused from growing the pie to splitting it well. An economic slowdown will hurt the underprivileged more than the affluent, while the key to social stability depends on the least well-off. Hence bringing forward the ideology of ‘common prosperity’ from Das Kapital, once targeted for 2050.

Global investors interpreted the statement as far left, focusing more on ‘common’ than ‘prosperity’. Corporates also reacted speedily, as large-cap internet platforms like Tencent, Alibaba and PDD all set up billion-dollar ‘common prosperity’ funds or realigned their corporate strategy to enhance social responsibility.

Looking beyond the turbulence

While the central government’s priorities are clear, the rigorous attitude has resulted in over-execution on the local level. Recent power outages aimed at curbing energy-intensive manufacturing spread to residential power usage in some provinces. The net-zero covid policy has also led to multiple rounds of reopening and closing of local businesses. August retail sales growth fell to a one-year low of 2.5%, and September’s manufacturing PMI contracted for the first time since the Covid-19 outbreak.

Onshore China eagerly awaits fiscal or monetary support on the slowing economy. Although it is too early to wish for a reversal of the clampdown, regulators have prepared a safety net to secure economic activities. As the fourth quarter is traditionally peak season for manufacturing and consumption, running such favourable seasonality into a macro-heavy calendar might be too costly.

Investing in this environment requires a change of focus, looking at policy-tailwind sectors that the authorities see as long-term leaders. The key word for the Chinese political agenda is ‘restructuring’; reducing reliance on labour and imported technologies, and overtaking incumbents in a Digital 4.0 world. China had a head start in decarbonisation technologies, so green development will be a major beneficiary of a changing political agenda. We are investing into the policy tailwind, with positions in the electric vehicle value chain, renewable energy and corporate digitalisation. Despite the big challenges facing China, there are still ample opportunities now and in the future.

Wendy Chen is senior investment analyst at GAM investments

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