What are the the risks and rewards of investing in China?
This summer China launched a new policy regime, which escalates government steerage of the economy and features two critical initiatives. This article, from one of GSFM’s manager partners Epoch Investment Partners, discusses these policies in detail and outlines what it might mean for investors.
There are two initiatives introduced by China earlier this year. First, Beijing has (finally) taken action to tame the country’s real estate obsession and speculative excesses. Second, the “summer blizzard” of regulatory actions has evoked crackdowns on a wide range of sectors, including online consumer platforms, fintech, gaming, private education and many more. We believe these policies mark a historic turn, with the pendulum swinging ever further in favour of the state.
The motivation for Beijing’s crackdown on real estate couldn’t be clearer: it represents 70%+ of household assets, and real estate- related activities account for a staggering 25% of Chinese GDP. Moreover, 87% of new homebuyers already have at least one dwelling, price-to-income ratios in major cities are the world’s highest (three times New York City’s), and the urban housing vacancy rate is 21%. These eye-popping statistics have finally compelled policymakers to address the economy’s over-reliance on debt- fuelled property investment to fabricate growth.
But why now? Concerns about excessive leverage and speculation are not new: Beijing has been worried since at least 2007 and the Fed first expressed alarm in 2004. What is different is that the workforce is now shrinking. The labour force grew by over 20% between 1990 and 2017, but since then has shrunk by 17 million.
Correspondingly, housing demand peaked at 20.2 million units in 2017 and is forecast to decline to 12.8 million units in 2030 (representing a bubble-popping 37 percent decrease). This demographic time bomb is terrible for Chinese real estate that, like all Ponzi schemes, requires fresh patsies to keep from imploding.
Despite the extreme imbalances, we do not expect a Lehman-type financial crisis as China’s closed capital account and huge current account surplus provide Beijing with sufficient capacity to prevent contagion and ensure households are protected. Further, since 2008 policymakers everywhere have learned to avoid “Lehman moments,” so a broad-based credit crunch seems unlikely.
Moreover, given how exposed and vulnerable households are, the government has every incentive to avoid a hard landing.
The best evidence that the market believes in such an implicit promise, a “Beijing Put” if you will, is the lack of any sell-off in investment grade spreads. Chinese high yield spreads have blown out to all-time highs (4+ standard deviations above normal), while investment grade spreads remain narrow (and tighter than their 10 year mean). This shows that investors are not worried about contagion from the real estate sector affecting markets more broadly.
Even without a financial crisis, a successful deleveraging and rebalancing necessarily implies lower overall growth over the medium term. Moreover, such transitions are fiendishly difficult and always involve collateral damage, meaning we’re likely to experience casualties in other sectors. Bottom line: China’s structural imbalances are enormous by any standard, so expect more shocks and volatility spikes over coming quarters.
The attack on tech: Au revoir to laissez-faire
Regarding regulatory tightening, the clampdown on internet companies has been especially aggressive, with China shedding what was once a relatively laissez-faire approach to the sector. Policy analysts believe many of Beijing’s actions were long overdue and echo programs enacted by their counterparts in Washington DC and Brussels.
This includes ramping up antitrust scrutiny, investigating anti-competitive behaviour such as mergers and acquisitions and exclusive deals, and litigating personal data violations. Beijing has taken matters further though, with online consumer platforms being forced to, on a rather ad hoc basis, raise wages, improve treatment of gig workers and make donations to charitable causes.
One negative consequence for investors is that the new policy framework will limit the upside potential for Chinese companies, especially in tech. Firms that become too successful and powerful, and whose activities don’t fully align with Beijing’s priorities, will find themselves in the crosshairs. The phrase in Japan is, “The nail that sticks out will get hammered down.” Incumbent tech giants, such as Alibaba and Tencent, will still be around but will be less overweening. In a nutshell, ‘10 baggers’ will not be allowed in the new China.
This is especially problematic given the winner-takes-most nature of the digital economy. For example, 40% of the S&P500’s rise since 2015 is accounted for by just six superstar firms. Given that we expect digital platforms to represent the majority of market capitalisation by 2025, this suggests the overall Chinese index is doomed to continued underperformance.
Common prosperity: New policy framework or just a catchy populist slogan?
Both of this year’s critical policy developments are associated with the “Common Prosperity” slogan that President Xi began actively promoting in August. This catchphrase is intentionally vague, but targets rising income inequality, excessive speculation and a host of anti-social activities (including gaming, frequently referred to as “spiritual opium”). For private enterprises, the “grand steerage” means greater emphasis on social responsibilities (to workers and the state), with the status of founders and shareholders taken down a notch.
With this new framework, Beijing is moving with an intensity not seen in decades. President Xi wants the state to more actively steer flows of capital, set tighter parameters for entrepreneurs, and exercise even more control over the economy.
And the timing is deliberate, coming ahead of the 19th Party Congress slated for October 2022, which will feature the next Five-Year Plan and the quinquennial personnel changes (President Xi hopes to keep his job). This made the summer of 2021 an opportune time to launch a catchy populist slogan and enact policies focused on housing (the largest driver of inequality), private education (to which the rich have much better access) and humbling tech billionaires (always makes for great headlines).
Regulatory uncertainty: Will it quash China’s entrepreneurial energy
One of the biggest risks is that the “Common Prosperity” regime suppresses the entrepreneurial spirit that has emphatically powered China’s boom. It is certainly the case that there has been a big hit to entrepreneurial confidence, and the fast-changing regulatory environment is making long-term planning more difficult. Moreover, it is widely believed the fluid, opaque and unpredictable regulatory crackdown will continue and not end anytime soon.
What sectors are favoured? Surpassing America and achieving tech independence
Beijing favours companies that create tangible advances in “deep tech” that will help China surpass America and shield against the risk of technology decoupling. President Xi has frequently championed AI cloud-computing and quantum computing, but also wants to create a more hardware-focused tech sector with AVs, sensors and homemade cutting-edge semiconductors.
Other broad priorities include high-end manufacturing to ensure China’s competitiveness, as well as power equipment and clean energy.
On the other hand, Beijing is actively discouraging businesses focused on speculative activity including gambling, that which increases income inequality (private education) and those deemed frivolous, such as social media, video games and other “spiritual opium”.
Regardless, when launching a new company, entrepreneurs and VC investors must increasingly ask: How does this solve China’s problems?
Is China investable?
To understand what the new regulatory environment means for investors, we first provide some historical context. Despite its booming economy, the overall Chinese market has exhibited terrible performance.
Since 2010, the MSCI China Index (MXCN) has underperformed the MSCI US Index (MXUS) by 63 percent, with IT being the only sector that did better than the US index. The next two best sectors were health care and consumer staples, while the worst were industrials and finance.
The CSI 300, a capitalisation-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange performed similarly against the S&P500, with its two best sectors being consumer staples and health care, while its worst also included industrials and finance (figure one).
The results over the last decade clearly are not encouraging. However, some investors make a more tactical argument, emphasizing mean reversion and suggesting the recent sell-off represents a good entry point. Although that might be true for some sectors and companies, it is not the case for the overall market. While Chinese indices almost always trade at a lower multiple than their US counterparts, the discount today is exactly at the 10-year mean (figure two).
That is, market weakness has simply reflected weaker relative earnings growth. Bottom line: There is neither a tactical nor a valuation argument for the overall Chinese indices.
The case against Chinese equities can then be summarised as: An elevated level of regulatory uncertainty, terrible relative performance since 2010, and yet the broad indices are still trading at their historical multiple (reflecting weak relative earnings growth).
Additionally, “Common Prosperity” is likely to limit the upside for many successful tech companies, which is especially problematic for the digital economy, where a small number of firms account for an oversized share of market gains. Finally, the macro picture is likely to remain challenging for an extended period as the property sector de-levers.
All this suggests the Chinese indices are likely to continue underperforming. However, it doesn’t mean the asset class is uninvestable. There are certainly some companies that will thrive in the new regulatory environment.
To identify such opportunities, Epoch has always favoured companies with effective capital allocation policies, including a demonstrated ability to deliver a return on invested capital above their weighted average cost of capital. We also look for companies with a record of generating free cash flow on a sustainable basis. Such companies are the most probable winners, and the above analysis suggests they are most likely to be found in sectors like health care, tech and consumer staples, while there may be relatively few candidates in finance and industrials.
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