Given the exceptionally strong performance of China’s equity market last year, what are your expectations for 2021?

I think China definitely did well in 2020.

It was up 27% compared to other markets. U.S. was up 20%. Europe was flat. It was the second-best performing, I think, among the EM countries. And where we are now, I would say fundamentals are holding up pretty well. Some of that might be optical, like it’s from a low base in 2020, et cetera, but many economical metrics do look good even compared to 2019 levels. In fact, some of the short-term indicators have never been better. The TSF number, PMI numbers, both surprised the market on the upsides.

For the full year, I think consumption growth we’re looking at 12% to 13%. Exports mid-teens. All very solid. So I would say fundamentals are good.

But there are headwinds for the equity market, and the most prominent one would be policy and regulation headwinds we saw in some of the sectors. Most evident would be the internet sector. We’ve seen anti-monopoly roles coming out and that’s hindering some of the major names like BABA, Tencent, and Meituan. And it’s not just the internet sector, unfortunately. There are other sectors like property and education, so on and so forth. So that would be one headwind.

And also you mentioned valuation. 2020 we saw pretty much the only thing was multiple expansion, and that’s likely to reverse. In most sectors, we are seeing historical high valuations except for sectors, maybe banks or big oil names. So some are frankly—some of these multiple expansions are frankly not justifiable. To give you an example, we don’t even need to talk about fancy internet names. Some of the stable companies were trading at 80 to 100 times for P/E where their historical high end was mid-30s.

So that’s going to change. And also liquidity. Globally, you’ve seen obviously U.S. interest rates are picking up, and that has led to higher liquidity situations everywhere. And in China, we’ve seen liquidity turns tight as well as we go into the Chinese New Year.

And so full year credit growth, we’re looking at low-teens. So certainly with that, it will be increasingly hard to square the high valuation we’ve seen versus the trend in liquidity. So I think that’ll be challenged for the remainder of the year 2021 as well.

So I think in short, some of the investment logic in 2020 will reverse in 2021, such as excessive liquidity, pandemic play such as internet, work-from-home, vaccines, et cetera.

But if we look from the brighter side, in the short term we have had that 20% correction in China since mid-February, and now we’re flat compared to year start versus, I think, MSCI World’s up 10%, 10% to 15% year to date. So the hot momentum has calmed and valuation has become more palatable.

And another thing is, if you look at the long term, a lot of the secular growth we’re looking at are still there, and then a lot of the structural theses we’re looking at such as household income allocation more to the equity market, those still stand.

So this year we just need to do a lot more bottom-up research and find the companies we like. This I think is a perfect entry point that’s being provided to us. So 2021 would be a good opportunity for us to select the companies we like for the long term.

From an investment standpoint, how does slowing globalization impact China and the rest of Asia?

I think it makes it more challenging.

It’s certainly true that in the last few years since the Trump presidency, but now it appears to be a bipartisan issue or supported directive in trying to make sure that, or trying to see China as the strategic competitor as opposed to more of a friendly ally. And the U.S. and China have gone down a certain route of seeing each other as protagonists as opposed to a relationship that was probably, in the last 15 years, a little bit more cooperative.

We don’t see that really changing. I do think that this anti-globalization trend does appear here to stay. It’s not just about the U.S. and China; we’re seeing popular or populist movements across the world, whether it be in Europe, India. The rise of the strongman. And it is certainly going to make investments more challenging.

What we see it is, is a change in economic relationships from a much more multipolar or multilateral trading system to a more unipolar or bilateral trading systems developing.

What does that mean? I think it definitely makes it more challenging for China in certain respects, the most obvious ones being technology transfers or getting access to higher levels of tech, especially if the U.S. puts sanctions in on certain companies transferring technology to local domestic Chinese companies.

But does it mean that China’s going to be isolated, which in theory could be a U.S. strategic objective, much like the Cold War saw the Soviet Union isolated? We think it’s highly unlikely. The Soviet Union had an economy that was much more reliant on one single factor, oil, whereas the Chinese economy’s incredibly diversified. And most importantly, over the last 15, 20 years, the Chinese government has made it—part of its ingrained into its own policies to try and increase trading relationships with a lot of countries around the world.

And the reason we think that while we may see a more separated global economy, i.e., an anti-globalized global economy where the U.S. has one pole and maybe China has another pole, it’s very hard for a lot of countries around the world to extricate themselves from a China relationship even if they wanted to. More than half the countries in the world, the main trading partner that they have now in terms of dollars and in terms of import-export relationships is actually China, not the United States.

So even if the United States remains politically powerful and says we want to try and isolate China, it’s going to be very hard to convince even allies to do that. So we think that while there are definitely going to be changes with the way countries interact with each other and it’s going to make investing a slightly more complicated thing to think about, we do think that China will remain an investable asset class and it will be very hard for people to ignore it as an investment, or to an asset allocator to completely ignore China in the next 10 to 15 years.

Will the Chinese government’s “Belt and Road” initiative continue to present compelling investment opportunities?

So the Belt and Road started in 2013. And if we look at total investment related to that, it really peaked in 2016 and ‘17, which was when China was easing liquidity conditions to help restart the economy. But since 2018, as China tightens liquidity to control debt, BRI investment has dropped substantially. So before 2018, we look at the total investment. It used to be really ports-driven, railway, power plants. Very capital intensive.

So now if we look at that type of investment, it’s actually very hard to fit in a China portfolio. Lots of companies [that] benefit are like China construction companies or railway companies. The earnings look very good, but they are also what we call deep value because they’ve permanently got cash flow and receivable issues, so it’s practically uninvestable.

So basically since 2018 and going to 2019, you can already see this big drop of investments. And on top of that in 2020 we have this pandemic and more defaults, more issue of repayments of debt. And obviously there are other things like geopolitical ambiance has changed, and China’s own priority is more inwards towards its own structural issues, all of that.

I guess China at this point has realized also being the biggest creditor to these countries, most notably the Southeast Asian countries, Central Asia or African countries, make it also very difficult for China to seize the assets or to get paid back. So the lendings on the BRI has become restrained and also the concept has shifted as well.

So Belt and Road hasn’t been abandoned. The Chinese government will be able to reframe it very easily. For example, a lot of the health care-related assistance they give to the Southeast Asian countries or African countries, now they’ll be able to put that under the category of Belt and Road initiatives. And also they’re talking about the digital Belt and Road, which are exporting digital knowhow and then apps and internet platforms, et cetera.

So I think Belt and Road is going to be one of the top leader, Xi Jinping, his signature geopolitical policies. So it’s not going to go away, and because the framework has been expanded so the investment opportunities for us is actually ample. But the good thing is, it’s not just limited to construction companies or the big national SOEs, which is actually a more amicable environment for us to invest or to choose from.

How do ESG factors weigh in to your decision-making process for investments in China?

RBC globally, and for all our investment teams, have a requirement to integrate ESG factors into our equity investments. So it’s a part of our process. It’s integrated within our process. When we look at any company, we will make qualitative and quantitative assessments on a variety of sub questions with respect to environmental, social, and governance factors.

Now these things vary when we look at different companies in different sectors. But from a very top-down perspective, we think about governance being multifaceted. Looking at things like management quality, management objectives and incentives, sustainability of a business. We look at accounting, and think of that from a quantitative perspective as being very important to understand whether a business is acting in a sustainable fashion.

And of course then we do a lot of work, which is more qualitative based, asking the right questions of management and we run things called checklists, which basically have a number of formulaic questions that we are expected to ask management to make sure that we understand holistically a business and the industry it’s in and whether we think long term these businesses are going to achieve the sustainable metrics that we think are important.

And this is important for a number of reasons. Firstly, our investors want us to do this. And we know who are our investors are, and they think this is important and we think it’s important.

Secondly, the sustainability of a business long-term is important from any investor’s perspective. There’s no point buying a company if you’re worried about a permanent or temporary impairment of your invested capital in that business because they can’t meet the environmental, social, or governance objectives appropriately.

And we don’t want to come in one day and have a headline in front of us saying this company is doing this and, therefore, it’s no longer investable. So we need to make sure that we do all of our work, and we need to make sure we do it well.

Specifically with regards to China, it’s very easy to pick on China because of a lot of negative headlines around the world. Some of these are related to accounting issues. And there have been some very notable frauds in China and we are aware of that. We use a number of different metrics to analyze our companies from a quantitative perspective. We use third-party forensic accountants to comb through the financials to try and make sure we’re not getting hoodwinked or investing in companies that may not be outright frauds, but borrowing aggressively from earnings in the future.

That’s more of an accounting issue or management quality issue. There is obviously also a broader issue that is being much more played out in the world media at the moment. Things like what’s happening in Xinjiang. And these are much more difficult questions to answer and ask, actually, to our companies. There are also obviously cultural issues that we must be aware of when you’re in it, and there are differences between Eastern culture and Western culture that we must understand.

But overall what we do try and do is make sure we avoid controversy and understand our companies and the risks that they’re taking. So a lot of Chinese companies will intrinsically be connected with certain parts of the economy that Western investors may find uncomfortable or troubling. And our rhema is really to make sure that our portfolio overall is defensible and make sure that the capital that we’re investing for investors is not at risk because of poor practices by the companies we invest in.

Our philosophy, fortunately, is very, one of looking for companies of a high quality. Returns on invested capital are very important to us. And these businesses tend to, therefore, avoid a lot of the particularly environmental issues that people can be concerned about, say carbon issues and so on. But also when it comes to other issues such as use of forced labour and so on, we do make sure that we ask the right questions of companies to ensure as best we can that we avoid such issues going forward.

But it is difficult, and sometimes it can be quite emotional, but these are all things that is part of our job. We have to make sure that we are mitigating risk, and that’s often how we look at ESG in this part of the world. We look at is as a risk mitigation exercise to make sure we’re not going to lose our clients’ money.