China’s equity market has bounced back strongly in recent months, and based on the fundamentals that we can see so far, we believe there is still a significant amount of upside. Mayur Nallamala, Senior Portfolio Manager and Head of Asian Equities, highlights 10 points around why the risk-reward for China equity is still attractive.
Where we started: to recap, there was a lot of pessimism and de-risking building up in the market right up to the 20th Party Congress in late October, and shortly after that point, as strict Covid policies hampered economic activity. At that point, valuation for China equity was at or below GFC levels. The share price divergence or valuation discount even with emerging markets was at historical levels. After China made a massive U-turn by dismantling its Covid policy, most investors were caught by surprise because it was so rapid and broad.
Where we are now: since then, the MSCI China Index is up around 50%. For short-term investors, especially those asking if it’s a good time to buy China equities at the index level and trying to time the market, it’s understandable that they’re asking if it’s too late or if there is still value to be found. But we need to remember that this is the second largest economy globally and it is broadening all the time, in terms of development and depth, and stock market access. We believe that the greatest appeal to investing in China equity is the many idiosyncratic alpha opportunities that remain available.
“After China made a massive U-turn by dismantling its Covid policy, most investors were caught by surprise because it was so rapid and broad.”
Where we’re going: there is much focus now on pent-up demand, and people want to dine out, meet people and travel. As activity levels pick up, so should meaningful consumption. Spending power is another reason that consumption may pick up in the short term. Government statistics show that during the last three years of lockdown, the average Chinese household accumulated quite a bit in excess savings. Some economists estimate this excess saving can be as much as 5-10% of GDP. The government has stated that “forcefully reviving market confidence” will be a policy priority for 2023, and has indicated support for spending in select industries.
How investors can benefit: unsurprisingly perhaps, the so-called reopening and pent-up consumption names were the first to rally last year and as a result many of these names are no longer at bargain valuations. Many names went from being cheap in October last year, to those related to reopening rallying in the last three months, somewhat indiscriminately. That’s why, throughout this year, we’ll be on the ground, monitoring how fast economic activity actually picks up and where that excess saving is spent. Some names that rallied in the past three months will disappoint on fundamentals, while others will exceed expectations.
Regulatory concerns are easing: over recent years, the government crackdown on internet companies was a major reason for growing scepticism around the China equity market, in addition to the regulatory crackdown on other private sector businesses, such as after-school tutoring. In late 2020, Alibaba’s financial arm, Ant Group was blocked from a major IPO that was expected to be USD300 billion1. At the start of this year, Ant Group was finally allowed to increase its capital. Regulatory concerns appear to be ameliorating now and the delta is certainly more positive.
The knock-on effect: the improving situation in China is likely to be a growth driver for Asian countries with strong economic ties to China. Japan, Korea and Thailand are popular holiday destinations for Chinese tourists, while Korea, Japan and Australia have many exports into China. While the global economy may see slower growth this year, China re-starting the engine should help to offset that to some extent. That said, there is growing concern over how ‘lumpy’ this might be and whether it can create inflation pressure globally, even sporadically. Demand is returning but supply has to be restored to pre-pandemic levels for that demand to get digested. This is something to monitor over 2023.
A new normal: the pandemic showed how excessively concentrated supply chains can be vulnerable, and there is uncertainty around deglobalisation. In our view, the last few years were a major wake-up call for companies and industries that had a particularly skewed supply chain. The start of a move to other Asian countries is something we’ll see pan out slowly but clearly over the coming years. Apple is a good example. Reportedly, it is seeking to accelerate plans to move production out of China and to countries like India and Vietnam. This could take years, however if big names like Apple move, that could really be a catalyst for other companies to follow.
“In our view, the last few years were a major wake-up call for companies and industries that had a particularly skewed supply chain.”
The rise and rise of ESG: as a team, we’re seeing notable improvements in this area and we’ve observed overall ESG awareness and related corporate disclosures making major leaps during the past few decades in Asia. Most of the major economies in Asia, including China, have pledged to be carbon neutral and it’s easier for us to engage with our investee companies now on how they see their carbon footprints and energy transition risks to their businesses. The same goes for other ESG issues related to social or governance.
A competitive edge: China has a major renewable energy industry and its electric vehicles industry is also renowned. Businesses have been investing in R&D and production capacity across the supply chain aggressively, both for domestic demand and in order to grow their competitive advantages globally. These businesses are actually seeing sustainability as a growth driver and building their business models accordingly.
Our on-the-ground perspective: we believe that there is still value to be found for equity investors, coupled with a need to be selective, with a careful understanding of what is happening in terms of fundamentals. We continue to do first-hand due diligence, and in particular our industry-specific understanding on ESG materiality for each business really makes a difference. As always, our long-term, fundamental approach means that we focus on finding good businesses that we believe in, while keeping an open mind to calibrate the growth outlook as we go.