Bull in a China Shop

Matthew Seaward
October 11, 2021

When momentum turns against you and sentiment is negative, it is important to revisit both the fundamentals and your original investment thesis. In this case, in this article, I revisit the reasons we like our Chinese exposure and companies linked with economic activity in this region.

Although I believe it is significantly more important to focus on business models rather than macro factors, I think it’s prudent to re-examine China’s macro and political factors to assess more deeply the risk in the companies. Chinese stocks haven’t continued their rally from 2020 into 2021 with both the Hang Seng and CSI 300 indices are down greater than -6% while European and North American markets have posted significant positive returns. While on a three-year view Chinese companies in aggregate haven’t performed badly: around 7.5% annualised (USD) vs 10% and 3.7% for Europe and the UK respectively. The Chinese A share market has delivered significantly more (21% annualised over the last 3 years). Given these stocks tend to be ‘under-owned’ by western investors and are listed in China, this raises multiple questions around positioning going forward with the non-domestic Chinese stocks being more e-commerce focused in nature than the domestic stocks.

Domestic stocks have been cited as possibly being more aligned with China’s last five-year plan (this is a manifesto setting out the economic goals for the near-term government policies). The policies from the 2016-2020 plan focused on moving up the value chain in manufacturing, innovation and addressing the wealth gap between urban and countryside regions. In the present 5-year plan 2021-2025, the goals are to become a moderately developed economy by 2035 with GDP per capita of $30,000, around 3x the present levels. It also prioritises domestic consumption or “dual circulation”, whilst also continuing the previous goal of addressing disparities in urban and countryside living standards.

Source: Bloomberg

Policy Reforms

The first half of the year was viewed as a window for making structural reforms by senor policy makers in China, these reforms have not been liked by the market and have come under criticism from foreign investors. Setbacks in markets are by nature uncomfortable and often lead to mispricing and some companies becoming ‘oversold’. This combined with the market shifting to have a more bullish view on Chinese stocks in February has led to both high volatility and significantly negative momentum in Chinese markets.

In my view, at its core, the new regulation has tried to focus on two themes. The first concerns wealth inequality and the almost three-tiered society that has been created since Deng Xiaoping started his open policy in the 1980s, and the second looks to reduce both the pressure on society and the consumption of demerit goods or at least goods which the CCP see as demerit.

I see some of the legislation as good in the long term, both for innovation and for the overall sustainable growth of the economy. The measures have included platforms no longer forcing suppliers to be exclusive as well as better working conditions for the army of delivery riders which power some of these tech giants.

Wealth Inequality and Income Growth

Whether you agree or disagree with the Chinese crackdown, it is important to try and understand where the other party is coming from. Although we would not profess to be foreign policy experts and don’t think we have any edge over our peers in this area, we do believe that as thoughtful investors, we should aim to understand the basics of “why” the government is making such decisions.

In 2000, the per capita GDP of China was around 16.8x higher than in the 1980 or 5x in real terms. The positive consequences of such a rise are obvious: better living standards and everything that comes with rising incomes. This had some negative implications; regional disparities in incomes grew and the gap between rich and poor widened along with this. At the time, Deng Xiaoping said it was acceptable for some people to become wealthy first which I believe marks the nuanced difference between socialism with Chinese characteristics and the western view of socialism. Fast forward to today and the GDP per capita has increased 24x since 1980 in real terms highlighting both a huge change in incomes over this period and graduation to an economy not producing most of its goods for other countries.

China wealth inequality remains high; to put this into perspective, according to Credit Suisse data, the top 1% hold 30.6% of the country’s wealth, below that of the USA at 35.3% but above that of the UK, Germany, and Japan. While in cities like Beijing, Shanghai and Shenzhen, the average salary is in the region of £17,000, Chinese Premier Li Keqiang highlighted last year that more than 600 million people in China still live on around £1,350 which he noted was not even enough to rent a room in a city. Addressing this disparity along with the gaps in welfare and healthcare looks to be of importance in the present 5-year plan.

What Risks do we see?

China’s economy growth is slowing, and downside risks are emerging. We identity three key risks:

Risk 1: Unexpected Reforms

The extent of this regulation can impact business in significant ways e.g. the education sector which saw the its business models permanently changed. We see both sides of this with growing financial and emotional stress being placed on families worrying about the cost of extracurricular tutoring for their children. The average parent spends around £12,500 a year on tutoring, which eclipses the average salary. (source: South China Morning Post)

George Soros’ article in the Wall Street Journal highlighted some of the challenges and risks (a lot of which the jury is still out on).

Risk 2: The Chinese Property Market

The property market which has been talked about for many years as being expensive, but has never come to a crescendo, looks now to have more semi-permanent problems. To put this “expensiveness” into perspective, properties in China tier 1 cities are 2 to 4 times more expensive than house prices in New York or London on a house price to income basis. (Source: Bloomberg)

With the real estate sector accounting for 10-15% of GDP, it remains a key driving force not only for the Chinese economy but arguably the global economy. After regulatory changes, one of China’s largest real estate developers, Evergrande, couldn’t issue debt, making their bankruptcy somewhat inevitable. This stress in the sector was most likely expected by policymakers who have both increased regulation around developers as well as implementing mortgage lending restrictions.

There are several reasons why the property market has remained so expensive: rising prosperity, a view that the local stock market is too risky and untrustworthy, capital controls and a belief that all married couples should own a house.

The government implementations, although bad for Evergrande and other developers, will likely reduce metal prices globally, helping to ease inflation in the mining and industrial metals industries which still have lower capacity due to covid overhang. I do not anticipate much volatility spill over or contagion from the Evergrande crisis outside of the real estate sector and think the government is likely to aid the company in a relatively orderly bankruptcy, with both bond holder and equity holders taking the hit.

Source: Bloomberg

Risk 3: A New Cluster of Covid-19

A rise in cases caused by the Delta variant has originated from Nanjing and has already spread to several provinces. A slowdown combined with headwinds might also arise from exports with the strengthening of the high yuan at 6.45/USD this year.

Reasons to be optimistic

Having mentioned the risks, we see the monetary and fiscal policy tone as relatively accommodating with fiscal spending headroom and the ability to step this up if required. I also see infrastructure investment rebounding towards the end of the year. Monetary policies in China will likely remain accommodating with additional reserve requirement ratio (RRR) cuts likely.  

Source: Bloomberg

We will likely hear more about the digital yuan as well which is still in a trial phase before mass adoption. We expect more noise about this nearer the beginning of 2022 with the Winter Olympics used to show off the new technology.

The risks pointed out above combined with a slowdown in the economy do not lead to a conducive backdrop for investment. Having said that, I remain confident that the GDP growth rate will be good: likely above +4% for the foreseeable future. Despite the slowdown China remains a core element of global growth, accounting for 33% in 2019 according to the IMF.

The labour market, especially in the younger population, is loose with the unemployment rate at 16.2% (link). This should have two effects: the first is that it hopefully acts as a barrier to regulation which could affect job growth, and the second is that it could help to reduce any wage inflation concerns which both Europe and the US seem to be facing.

In addition, I see a lot of Xi Jinping policies as necessary. While the economy shifts from emerging to developed, it is important to reduce corruption and try and iron out some of the extremes in health and wealth inequality. It looks like Xi Jinping will be President for at least another term, but it’s my belief that he is likely setting up the next leadership with the option for a more open economy based on a position of strength. Reforms in the country’s bond and equity markets look to be a welcomed positive. The Chinese equity markets are large — over $6 trillion more than twice that of the London Stock Exchange — and the bond markets are the second largest in the world.  The government is encouraging less sentiment driven investing from the largely retail equity market and has focused on addressing liquidity in bond markets, given this market is dominated by institutional investors who typically hold to maturity. This all comes at a time when many asset allocators are calling for a standalone allocation to China in portfolios.

There are other reasons to remain optimistic; China remains a centre for innovation, with Chinese AI companies continuing to raise similar amounts as their US counterparts, attracting investment of over $25bn in 2019. China looks set to dominate in electric vehicles and has the largest share of global lithium battery manufacturing with a 65% share.

I expect the dual circulation strategy to work well with China’s upper middle-class population expected to be close to the total US population by 2030. Upper middle-class is defined as having monthly household disposable income of greater than 14,000 RMB, roughly $2,000. We are now starting to see local brands emerging which are taking market share from foreign brands.

On a historical basis, valuations look compelling for both emerging markets and Chinese equities vs. developed markets. The forward price to earnings multiple on developed markets is around 20x while China trades on 13.6x. Further to this, the CAPE ratio* of 14.8 is at the 36th percentile of its historical range, while global developed trades are at 29.1 at the 90th percentile. They also remain underweight in investor portfolios by most common measures.

Although the risks associated with China are high, I believe the opportunities outweigh the risk, as any market, and perhaps Chinese sentiment driven markets in particular, can quickly move in and out favour. In summary therefore, I remain extremely positive on the innovation, valuation, and breadth of the companies I see in this large market. Finally, I leave you with a quote from Benjamin Graham which I think sums up many of my views:

"In the short run, the market is a voting machine but in the long run it is a weighing machine."

*CAPE ratio the cyclically adjusted price to earning ration is a measure of price divided by an average of 10 year earnings all adjusted for inflation