China’s corporate giants have been cut down to size, giving space and light for innovative companies to grow says Ming Kemp, Manager of the LF Canlife Asia Pacific Fund
After a stellar performance in 2020, China has been one of 2021’s worst-performing equity markets. At the time of writing (mid-December) Chinese equities have fallen c.20% for the year to date and are sitting some 30% below their mid-February peak. How could things have gone awry so quickly?
China reaped the benefits of responding swiftly and comprehensively to the coronavirus pandemic by becoming the first nation to emerge from lockdown. At the start of this year the country’s economy was in good shape, with Q1 2021 year-on-year GDP up c.20% as domestic consumption rebounded and exports boomed.
The economy was firmly on track but credit growth was starting to slow as the Chinese government reduced economic stimulus and shifted its focus towards deleveraging. After an initial recovery, consumption tapered off when successive virus flare-ups met with China’s effective but restrictive ‘zero covid’ policy. Corporate earnings growth began to slow due to rises in input costs caused by disrupted global supply chains. Meanwhile, tightening credit conditions began to put strain on China’s highly leveraged property sector.
The great regulatory reset
By itself, the economic slowdown might not have been a major cause for concern among overseas investors, many of whom expected an uneven path to full recovery. However, hot on the heels of deleveraging, the Chinese government began to turn its attention towards addressing long-standing imbalances in the economy through a series of regulatory reforms.
These were directed primarily at large internet and education technology companies, two key areas for overseas investors in Chinese equities, causing sentiment in offshore Chinese equity markets to nosedive. Accustomed to seeing shareholder value take priority over most other issues, many overseas investors were caught off-guard by the speed with which the Chinese authorities were able to introduce new regulations without extensive consultation or legal challenges.
Overseas investors are now generally pessimistic about the outlook for Chinese internet giants such as Ant Financial, Alibaba, Tencent, Meituan and Didi. Many see the current regulatory changes as, at best, anti-business and they are wary of further sudden regulatory change.
One door closes, another opens
Investors based in China, on the other hand, are more sanguine, seeing the regulatory changes as long overdue and to be expected in the context of China’s Common Prosperity policy. They also acknowledge that the changes are at least partially justified by the tech giants’ oligopolistic and predatory practices, which are not dissimilar to the behaviour of leading tech names in other markets.
It is notable that some of China’s regulatory initiatives echo rules in the US and Europe. For example, China’s Personal Information Protection Law is designed to regulate the collection and use of personal data collection. Likewise, new Chinese laws designed to protect gig workers have parallels in many developed markets.
As well as welcoming the curtailing of the tech giants’ power, many Chinese investors believe that the new regulatory framework and a more competitive environment should enable a range of smaller, innovative companies to flourish. For example, the Chinese government is keen to support investment in high-growth areas such as green energy and decarbonisation. Already the largest global players in solar power, Chinese companies aim to replicate that success in the market for electrolyzers used for producing hydrogen.
On the macro front the clouds are gradually clearing. This month there were clear signals from the 2021 Central Economic Working Conference that Chinese policy is shifting towards stabilising economic growth. In setting its economic course, China is not without options. There are few signs of domestic inflation pressures, giving the People’s Bank of China the headroom to bolster a slowing economy with credit growth and give a much-needed boost after 18 months of deleveraging.
We continue to be cautious towards the Chinese real estate sector, where the ripple effects of property giant Evergrande’s financial difficulties are yet to be fully felt. However, contagion from Evergrande into the financial sector is unlikely because of the deleveraging that China’s banks have undergone over the past few years. Moreover, given that the liquidity issues in the property sector are largely policy-driven, it is within the Chinese government’s power to avert a systemic incident.
In time, the recent spate regulatory and economic reforms could bring significant long-term benefits to both the Chinese people and investors. In particular, redirecting capital and resources away from real estate is likely to discourage the hoarding of wealth in property assets and may boost general consumption and competitiveness.
Policy risk will be a constant companion in the Chinese equity market – as will geopolitical risk and a rogues’ gallery of other risks. Investors who are seeking high short-term gains should probably look elsewhere. For long-term investors who have the patience to weather volatility, ample growth opportunities await.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
Due to the underlying assets held, the price of the LF Asia Pacific fund is classed as having above average to high volatility.
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