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China’s new antitrust, data privacy and cybersecurity regulations, combined with its education and real estate industry reforms, the continued impact of COVID-19 and rising geopolitical tensions, drove a tumultuous investment environment last year. The country’s numerous headline-grabbing changes spurred global concern given the philosophical shift towards “Common Prosperity” and the sheer scale and speed of policymaking.
Looking ahead, we seek to interpret the events of 2021 in context. Regulatory shifts are not new in China, and, with the benefit of hindsight, there are clear reasons so many changes came so quickly. Critically, several structural drivers have helped the country’s equity markets globalise and appreciate during the past decade despite multiple periods of significant regulatory change. We believe those drivers will endure going forward.
In this piece, we address a common set of questions from clients following last year’s events, offering our perspective on the balance of risks and opportunities we see in Chinese public equity markets.
China’s key risks in context
After the first half of 2021 brought an apparent inflection in the global pandemic and strong economic data, Chinese policymakers seemingly seized a brief window of opportunity to make their marks ahead of the 2022 National People’s Congress. The resulting barrage of new policies came as China’s GDP growth is structurally decelerating and transforming. Investment-led infrastructure and manufacturing growth is slowing while innovation, localisation and evolving consumption increasingly power the economy. This environment of slowing growth added to the pressure on leaders to address social issues such as the burden of after-school tutoring costs and income inequality.
China’s key areas of recent change and potential future investment risk are complex and multifaceted, creating significant associated uncertainty. Below, we offer a glimpse into how we put these issues into perspective as well as how we frame our base case looking ahead. We’ve provided links to more robust perspectives on many of these topics at the end of this article.
- After-school tutoring industry restructuring: We do not believe that the sudden shift of the after-school tutoring (AST) industry to a not-for-profit structure should be viewed as China taking a step back from either capitalism or integration with global capital markets. We view the reregulation of the AST industry as a distinct response to unique circumstances: in parts of China, AST had risen to the second highest household spending item behind mortgage payments at around 10% of income.1 We do not expect this type of reform to be replicated in other industries.
- Domestic regulation: China introduced a series of antitrust, cybersecurity and data privacy regulations in 2021 creating winners and losers, increasing uncertainty, and weighing down sentiment. These actions most heavily impacted the internet or “platform” economy. In many ways, this regulatory thrust was aligned with policy focus areas in the US and Europe, although the implementation was notably more rapid and less transparent. We believe the brunt of these new policies is now established, although incremental additions and regulatory actions are likely as the political cycle approaches its peak.
- Real estate industry reforms: We think China’s recent real estate policy has been focused on reducing systemic risk and rooting out moral hazard. With that in mind, we believe the government engineered the challenges experienced by Evergrande and others to force progress. In our view, there is a growing body of evidence that suggests Chinese policymakers believe they have set into motion the desired changes and will loosen policy from here.
- Geopolitics: We are living through one of the most complex and challenging geopolitical landscapes in decades. We expect to continue to see elevated tensions and strategic decoupling between China and the world’s western democracies, with Russia’s invasion of Ukraine potentially straining the relationship even further. However, the mutual economic dependency between China and the west is likely to confine structurally rising tensions.
- COVID: China’s zero-COVID policy has helped it avoid the economic trauma experienced by nearly all other countries globally. But we do not believe that the zero-COVID policy is a viable long-term policy option. China will need to adapt its current approach, resulting in economic uncertainty and market volatility. The transition risks are mitigated by the fact that China did little to stimulate in 2020 and 2021 and can deploy a variety of tools to cushion potential downsides.
Where we see opportunities in China
In our view, Chinese equities currently offer reasonable valuations, the likelihood of domestic policy support and the potential for lower correlations with other global risk assets. They have underperformed most other regions including the US, Europe and India since the start of the pandemic. Today, we believe Chinese equity market multiples appear reasonable relative to their own history while discounts to other key markets, such as the US, are near historical highs.
Importantly, unlike the developed world, the Chinese economy needed little stimulus in 2020 or 2021 amid the pandemic. In fact, the Chinese central bank’s balance sheet has been shrinking while the Fed’s expanded. It is now smaller as a percentage of GDP relative to that of its US peer. After emphasising reform in 2021, we expect the Chinese government to be both willing and able to support the economy this year. Notably, China faces less inflation pressure than the West and recently cut rates with room to move further. Taken together, we believe China’s economic cycle may exhibit limited correlation to that of the US and EU in the coming years.
Within this environment, we see several enduring areas of investment opportunity. Crucially, we do not believe that slowing GDP growth diminishes the return potential of Chinese equities. As US equities have demonstrated over the last decade, dramatic headline growth is not required for large economies to generate attractive equity returns.
- Innovation: Increasingly, Chinese companies are competing with the benefit of technological advantages or differentiated intellectual property. We see attractive opportunities to invest in health care, materials science and internet businesses, among others, that we believe display these qualities and offer strong organic growth fuelled by reinvestment of healthy margins.
- Localisation: Chinese companies also continue to localise their supply chains supporting domestic or regional brands. Bolstered by this rising demand, local companies are investing to reinforce their natural advantages stemming from proximity to their clients, including better customisation and flexible servicing. In addition, slowing domestic and export growth are expected to drive persistent industry consolidation, adding another compelling facet to this opportunity.
- Evolving consumption: China’s legacy growth model was dependent on exports and government investment. After two decades of rapid growth, the Chinese consumer sector is now the heart of the economy. As disposable income continues to rise, millions of Chinese consumers are seeking to upgrade their purchases, producing opportunities for businesses to grow margins through mix shift towards premium products.
Investing in China: the big picture
China has one of the world’s largest and most dynamic economies. Regulatory shifts are part of industry development globally and are understood and expected within China. Looking ahead, we believe innovation, localisation and evolving consumption all generate exciting investment potential. The Chinese equity market — encompassing domestically listed A-shares, Hong Kong listed shares, US listed and traded companies and ADRs and other instruments — offers investors a broad set of potential investments. Not only is the opportunity set large and diverse, but retail participation in equity markets remains high, supporting abundant liquidity. We believe this environment creates an enormous opportunity for skilled institutional active management.
1Source: OECD, UNESCO, World Bank, Euromonitor, Ministry of Education of PRC, National Center for Education Statistics, Wind, UBS-S estimate
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