China is something of a new frontier for institutional investors. And for those with the knowledge and understanding of the country, it has been so for some time. It continues to grow in so many ways, offering investment opportunities aplenty along the way. But where, given the size of its economy, are the best opportunities for investors to exploit?
For local government pension pool Border to Coast, which has a big focus on the country, healthcare appeals. “The healthcare sector is an exciting part of the Chinese market,” says Luc Pascal, assistant portfolio manager. “At a high level, the sector is supported by two key tailwinds, an ageing population and increasing healthcare spend per capita.
“These positive macro forces, along with a culture of innovation, should prove supportive for prolonged revenue growth – as well as being positive at the social level – with better, more accessible healthcare,” he adds.
Pascal notes that despite positive tailwinds for the sector, there will still be individual winners and losers. “For example, there may continue to be downward pressure on generic drug pricing in an effort to reduce basic healthcare costs,” he says. “Understanding the intricacies of the sector is very important.”
China is so central to Border Coast’s approach that the investment team re-adjusted its Emerging Market Equity fund to focus on the country. Of particular interest within this new concentration, are high-growth companies.
“Carving out a standalone allocation to China was the culmination of a lot of thought and debate here at Border to Coast and with our partner funds,” Pascal says. “We believe there is scope to generate attractive levels of alpha in China, particularly in the domestic A-Share market, so we sought to reposition our fund to best capture that opportunity.”
The changes made, have, thus far, showed promise. “Performance from our new China allocation has been encouraging so far,” Pascal says.
Property is another area that offers vast investment opportunity. “We believe China is rich with opportunity, but there are also risks to be cognisant of – for example, the property sector,” Pascal says. There are also opportunities in new industries. China needs to upgrade its electrical grid infrastructure and develop energy storage systems to improve power supply and distribution, says Chi Lo, a senior market strategist, Asia Pacific, at BNP Paribas Asset Management.
“It also needs to wind down its fossil fuel consumption by using more green electricity and achieve a structural shift from energy-intensive heavy industry to high value-added segments to boost energy efficiency,” he says. Chi estimates new-sector investments will amount to $781bn (£573bn) a year – about 10% of China’s annual total fixed asset investment – over the next decade.
Given the transformative nature of much of the Chinese economy, innovation and technology are on the list of sectors with the potential to offer long-term investment success. And the potential for long-term success is what Border to Coast looks for. “When we think about investing in China, we like to do so through a thematic lens – for example, innovation and technology or the transition to a greener economy. Within each theme are businesses we think should experience long-term success,” Pascal says.
“As an example, we believe that the continued growth of the Chinese middle class will support consumption growth and premiumisation,” he adds. “This should benefit a variety of names, whether they be businesses producing dairy products or highly-prized liquor manufacturers.”
Some may raise an eyebrow at the idea of a transition to a greener economy within all the opportunities in China, given its position as the world’s largest emitter of greenhouse gases. But Chinese president Xi Jinping has committed the country to reach carbon neutrality by 2060 – and with that will come opportunities, says BNP Paribas’ Lo.
Nevertheless, the Chinese approach to climate change, and ESG issues in general, has been a source of debate, and indeed scorn, for some time. How can institutional investors square the circle on meeting ESG investment demands while benefiting from the investment opportunities in China?
Border to Coast takes a focused approach to investing in the world’s second largest economy. “Our partner funds are committed to being responsible investors,” Pascal says. “This is one of the reasons we have invested with specialist managers in China that fully integrate ESG issues into their investment processes.”
“Our managers have boots on the ground and so are close to these issues. They live and breathe them in many ways and are best-placed to understand the risks and opportunities,” he adds.
On another, but different, worrying level there have been numerous reports of a business crackdown in China. “Are we concerned? No. Are we complacent? Absolutely not,” Pascal says. “President Xi’s ‘common prosperity’ agenda and long- term objectives, such as technological independence, will have material implications for most corners of the Chinese investment market. But it is not all doom and gloom.
“Yes, some sectors will face headwinds – we have already seen the after-school tutoring market collapse – but there will be tailwinds for others,” he adds.
Yet one asset manager challenges reports of such a strategy by the authorities. “There is no such thing as a business crackdown.
“China has been working to regulate its technology sector and bringing businesses to cut financial leverage,” they say. “The global technology industry needs regulation on a global basis due to monopolistic practices, an unfair tax system, content control and other massive regulatory arbitrage versus traditional sectors.”
It is worth noting that China has pursued regulatory action at various times over the past 20 years against industries considered as becoming too comfortable or wealthy at the expense of the wider population.
This policy is known as ‘common prosperity’ and has focused on telecommunications, technology operators and banks. It now appears to be turning on the possible excesses of the real-estate sector.
“Investors need to look through the negative headlines to identify the opportunities,” Pascal says. “As an example, the drive to be technologically independent should act as a tailwind for innovation in the semi-conductor and software sectors.”
For Richard Bullock, senior geopolitical research analyst at Newton Investment Management, the situation with common prosperity potentially raises bigger questions for investors. “Investors are well justified in asking whether China has entered a new socio-economic paradigm and whether socialism with Chinese characteristics isn’t just a cover for plain old-fashioned socialism,” he says.
“It can feel uncomfortable for investors and discriminatory against certain industries and companies, but in the medium term it can foster a cycle of renewal and the flourishing of new investment opportunities,” Bullock adds.
Craig Allen, president of the US-China Business Council, which advises and represents US investors in China, highlights the investor uncertainty surrounding the common prosperity idea. “Portfolio investments have largely been investing in industries that are not open to foreign direct investment: EdTech, for example. Media is another good example, and those are unfortunately the areas that common prosperity has affected.
“We will see where common prosperity goes, and how this regulatory flurry will right itself over time. And we don’t know the answer to that question yet,” Allen adds.
What will override investor doubts in the end is the fact that the prospects for the Chinese economy are moving in one direction: upwards. Late last year president Jinping asserted that China will double the size of its economy by 2035. To achieve this, GDP must grow annually by a tad more than 4.7% on average for the next 15 years.
In western terms, these are dream-like growth numbers. Not so in China. The Chinese economy grew by 6.1% last year, and by 6.7% on average in each of the previous five years. Although looking back also gives an indication of what the future holds.
Michael Pettis, finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Centre, notes that countries following the high-saving, investment-led growth model that China adopted in the early 1990s – examples he cites are Japan in the 1970s and 1980s and Brazil in the 1960s and 1970s – have gone through three distinct stages.
The first, characterised by heavy investment in much-needed infrastructure, delivered many years of rapid growth. In this stage, debt grew in line with the economy because when debt mostly funds productive investment, gross domestic product grows faster than lending.
In the second stage, each country sought to rebalance demand away from investment, typically with little success. Growth remained fairly high, although it is now driven increasingly by non-productive investment. When this happened, total debt in the economy grew faster than GDP, resulting in a growth of the debt burden.
Finally in the third stage, the country either reached its debt capacity ceiling or a worried government took steps to prevent lending from rising further. Either way, the economy was forced to rebalance away from investment and towards consumption amid far slower, sometimes even negative, growth. On this analysis, China is still in the heady days of stage two. But stage three is up next and reality could well bite.
There are parts of the economy that could already be seeing cracks as a result. “China’s economic growth is uncertain,” one wealth manager warns. “Much of the recent slowdown has been fuelled by the wider impact of the collapse of huge property developers such as Evergrande.
“There are now serious worries that this could initiate a worrying credit crunch that would be disastrous for the world’s second-largest economy, which would have global repercussions.”
On such an outlook, should there be a limit to how much investors should allocate into the country? “Any investment, whether it be an allocation to Chinese equities or UK corporate bonds, should be considered holistically – and against a set of long-term objectives and constraints. For example, risk tolerance,” Pascal says.
Instead, Pascal presents a different China narrative. “More broadly, we have seen other market participants claim that investors are under allocated to China when you take into account the size of the investment opportunity, the potential for growth and the diversification benefits an allocation to China can bring to a portfolio.”
On the point of investors keep an eye on the developments within the political sphere, Allen notes: “On portfolio investments, one needs to be careful to listen to the words of the Chinese leadership, to watch where they want to go and invest with the flow.
“China is not anti-entrepreneur or anti-business at all,” he adds. “But it is insistent that Chinese priorities be met, that Chinese social issues are addressed and that Chinese law is followed. If you are not comfortable with that, it is probably best to invest elsewhere.”
China is still capable of real innovation and at a comparative advantage. One portfolio manager says it is likely China will strive to build its own biotech industry, which can deliver at a price point that beats all competition. “Over time, as we have seen in areas like semi-conductors, AI and robotics, there is a strong chance that China can catch up in totality, versus US and European capabilities,” he says.
This presents a picture of the continuous rise of China, with China’s investment-led approach delivering high returns for the foreseeable future.
And it is on the strong macro-economic factors that contribute to the convincing arguments for institutional investors to gain exposure to the country. “China is evolving as an economy, shifting away from manufacturing and exports and towards services and consumption,” Pascal says. “The population is becoming more urban, is ageing, is becoming wealthier and more environmentally conscious. All of this will create opportunity for investors.”
A key lesson for other investors and asset owners to follow is not just dipping in and out of the country but getting in at the ground level. “In our view, having boots on the ground and an understanding of cultural and regional differences is key to extracting long-term value,” Pascal says. “We see lots of opportunity in China, and not just in those sectors that you would consider high growth.”