Is China investable? We think so.
New regulations from Beijing have wiped billions out of Chinese markets. Despite turbulence, we think investors can still navigate Chinese assets.
Our Top Market Takeaways for July 30, 2021.
Markets in brief
A Midsummer Night’s Dream
Let’s quickly touch on what we won’t cover this week:
- The Fed got together, said that the economy was making progress and seemed to lay the groundwork to start tapering asset purchases toward the end of the year.
- The second quarter GDP report showed that the U.S. economy, driven by strong consumption, has recovered past its pre-COVID peak.
- In Washington, the Senate and the White House coalesced around a $1 trillion infrastructure bill that includes over $500 million for transportation, broadband and utilities.
- Robinhood, one of the main characters of the Gamestop saga, had a poor public debut. Shares of the app-based brokerage closed almost 8% lower than the IPO price.
- Finally, 50% of the S&P 500 by market cap will have reported earnings this week by the end of the day on Friday. Of the 274 companies that have reported earnings numbers at the time of writing, 240 have surpassed analyst expectations. Index-level Q2 earnings are on track to grow by more than 80% versus a year ago.
But the most important development of the week actually happened last weekend, when policymakers in Beijing banned for-profit education companies from, well, earning profits. The market cap of the industry has plunged from $100 billion at the start of the year to just $10 billion.
Is China investable?
The move is just the latest in a series of actions that has investors spooked.
In November 2020, regulators nixed the Ant Financial IPO just days before the company was set to raise almost $40 billion. In December, the State Administration for Market Regulation launched an anti-trust investigation against Alibaba, the e-commerce giant. In March, that same agency fined 12 different companies, including Baidu and Tencent, for insufficient reporting of previous mergers. In July, Didi Global, the ride-hailing app, was banned from registering new users just two days after its $4.4 billion IPO in New York. Let’s not even start with what they did to crypto miners.
When you write it all out like that, the poor performance this year is hardly a shock. The MSCI China index has lost ~10% this week, and is down over -15% so far this year. Out of a universe of over 80 equity, bond and commodity markets that we track, only Turkish stocks and bonds have had a worse year. Indeed, Chinese internet stocks are at the epicenter, and are now down over -40% from all-time highs reached in February. Given that China makes up around one-third of Emerging Market equity indices, the asset class has been a disappointment overall, even though equity markets in Russia, Mexico, Taiwan and India have delivered positive mid-teens returns. Overall, MSCI EM ex-China is up +9% so far this year.
Investors are asking questions, the most important of which is: “Is China investable?”
For the last several years, investors have been operating under the assumption that the Chinese government was prioritizing the development of its capital markets, and that it wanted to attract foreign investors. The current regulatory environment is calling that status quo into question, raising questions over policy transparency, willingness to allow foreign capital in tech companies and government influence over private companies. All of this calls into question what the future operating environment looks like and how social and national priorities mix with shareholder interests.
Chinese officials are already working to calm markets, and Chinese internet stocks were ~15% higher heading into Friday than they were at the lows on Monday. However, valuations will probably remain under pressure because other initiatives seem to be taking priority at the moment and investor uncertainty remains high.
It’s important to understand there are clear domestic motivations for each action—the actions against Ant Financial are meant to rein in shadow banking. The actions against Tencent, Alibaba, Baidu and others are meant to trust bust. The actions against Didi are meant to protect data. The actions against the for-profit education sector are meant to ease the financial burden on households to incentivize higher birthrates. At the moment, China seems more focused on establishing what it deems to be sound financial and social policies domestically rather than catering to foreign investors.
And what steps might policymakers take next? It is not easy for Chinese companies to raise capital directly from foreign investors. Many, including Didi, Tencent and Alibaba, have utilized variable interest entities (VIEs, a legal structure that sort of obfuscates the real essence of ownership) in order to avoid rules regarding foreign ownership to raise capital in places like New York. Many worry that Beijing will make companies seek approval to use this tactic, or, in a draconian flourish, declare that they were never allowed in the first place. We think that more oversight is likely, but that it is unlikely that Beijing will immediately disallow VIEs.
In terms of sectors, housing and healthcare costs are, like education, cited as concerns by parents. We would suggest avoiding property developers and generic pharmaceutical companies.
So how should investors consider positioning in China?
For now, we would suggest focusing on three specific areas within Chinese equities: onshore stocks, companies in industries that have policy support and profitable tech companies.
- Onshore equities have a higher degree of Chinese domestic ownership, so regulators will probably have a lighter touch so as not to hurt Chinese savers. Further, there is less exposure in the onshore market to the industries in the regulatory crosshairs. 50% of the offshore MSCI China is related to internet, healthcare, education and real estate, but only ~15% of the onshore CSI 300.
- State-owned banks, semiconductor manufacturers, clean energy and electric vehicle suppliers, and companies involved with automation should be more insulated from regulatory ire given their strategic importance.
- Finally, after a dramatic selloff, the valuations of large profitable tech companies are at trough levels and they are well into the regulatory review process. A lot of bad news seems to be priced in. The odds could be in investor’s favor from here as it relates to the big, profitable tech names.
For investors in broad emerging market equities, there are still reasons for optimism over the medium term. Emerging markets are less reliant on foreign capital now than they were in the last decade and inflation is relatively low. Earnings expectations seem to be setting a low bar. We still see compelling opportunities in places like Taiwan and parts of Latin America, and continue to prefer active managers who can navigate turbulence like a more onerous regulatory environment in China.
It may be hard to imagine the light at the end of the tunnel for Chinese equities, but we think we are getting closer, day by day.
All market and economic data as of July 2021 and sourced from Bloomberg and FactSet unless otherwise stated.
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