More broadly, some of the tailwinds that have supported Chinese growth over the past decade are fading. Demographics, for example, will soon begin to dampen growth potential. The government is working to lower health care costs and make education more affordable in an effort to mitigate the social impact of slowing growth.
Importantly, however, lower aggregate economic growth does not directly translate to lower equity returns. Within China’s now vast public equity markets, we see attractive and enduring investable themes — including consolidation, localization, and a growing focus on margins — with the ability to drive China’s upside potential in the years ahead.
Consolidation — Many sectors remain fragmented with thousands of players with weak bargaining power. But pricing power, excess capital, and consumer taste are becoming more differentiated. We believe these large markets are facing consolidation pressures and market share winners stand to benefit.
Localization — Supply-chain disruptions have driven business to local players — particularly in technology, industrials, and health care. These companies are investing more into research and development and thus are closing the gap on leading multinationals. So, even if the pie isn’t growing as much, local leaders can meaningfully grow the topline by taking share from international peers. Local players are supported by an ability to offer better customization and customer service and may also benefit from favorable policies as governments continue to regionalize global supply chains.
Margin improvement in operations — Chinese companies were historically focused on topline growth but are increasingly shifting governance and corporate cultures to drive margin improvement.
For many investors, the question is whether China can generate excess returns versus the rest of world going forward. We believe Chinese equity returns will be driven by the quality of the underlying companies and the price paid for ownership stakes. Critically, we think current Chinese valuations reflect the underlying political and regulatory risks, which contrasts with many developed markets and the US in particular, where valuations have become increasingly extended.
We expect continued volatility next year as President Xi positions himself to be appointed to an unprecedented third term and other senior party leaders vie for key positions coming into the 2022 National People’s Congress. Notably, some of the politicking that typically occurs on the election year has shifted earlier compared to previous cycles. We believe this headline volatility offers significant opportunities for investors to build exposure in China’s compelling underlying structural tailwinds.