China: Time for a re-think?


30 Apr 2024

Is the world’s second largest economy still a sound institutional investment? Andrew Holt investigates.


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Is the world’s second largest economy still a sound institutional investment? Andrew Holt investigates.

China appears to be in crisis. Its markets are experiencing nightmarish scenarios and the property sector has hit catastrophic proportions. 
But what does it mean for investors, especially those investing for the long-term? Is it time to retreat from the market? And if so, as a long-term punt, has it had its day?

The economist Mohamed El-Erian has said that foreign investors are now right to see China as a trade, more than a long-term option, which is damning in itself.
 But investors appear to be taking a more measured view.

David Perrett, co-head of Asian investment at M&G Investments, says there are solid reasons for investors to remain constructive on China. “We believe that pessimism about China’s fortunes and the wider economic outlook, resulting in the sell-off, is presenting opportunities for active investors to find national and global leading companies at attractive valuations.”

Indeed, he adds a further warning on the short termism of some investors towards China. “By focusing on near-term uncertainties and recessionary fears of weaker profits, we believe many investors are overlooking the longer-term prospects for companies that either have powerful structural tail- winds behind them or enjoy strong competitive positions,” Perrett says.

Consumer market

In a similar way, Nicholas Chui, an emerging markets equity portfolio manager at Franklin Templeton, says that market valuations in China do not reflect the potential of the longer-term outlook of the economy and the stock market.

“We are most excited about the longer-term prospects of the domestic economy in China – anything that is made in China, for use in China,” Chui says. “This is underpinned by the sheer level of innovation that has been happening over the last few decades, and more importantly, that China has been upgrading how it consumes.”

However, Chui says no one seems to be paying attention. “If we look at the market returns for 2023, the MSCI China fell by around 13%. However, approximately 15% of this was a sheer de-rating of the market. Whilst the remaining implied 2% earnings growth is nothing to shout about, the latter has received very little attention, if at all,” he adds.

Within the 2% earnings growth, the trends have been divergent, but this does reveal investors need to be alert to developments and opportunities. Sectors such as property dragged down the overall picture, but this also meant that the growing areas did not receive any attention. “As bottom-up long-term investors, that gives us time to build positions in the stocks we like,” Chui says.

But, adds Susannah Streeter, head of money and markets at Hargreaves Lansdown, the property market situation is a concern. “China’s property woes extend deep into the economy. Construction fired up growth in China over the last few decades as urbanisation accelerated, fuelled by debt, and efforts to rein that in and tighten regulation have caused a big wobble. “

This matters, Streeter says, “because the property sector accounts for some 30% of GDP. Already chunks of the property house of cards have begun to collapse, such as the giant Evergrande, now in liquidation in Hong Kong.”

Longer themes

But for Chui, despite such woes, there is a simple and easy conclusion to make: long-term investors should be investing in China, not retreating. “Within the domestic China play, there are attractive longer-term themes,” he says.

Reinforcing this view, Kelly Chung, chief investment officer of multi-asset at Value Partners, says company earnings in China are bottoming and macro data is gradually improving. “Separately, the country’s Two Sessions [the Chinese government’s annual plenary sessions of the National People’s Congress and of the Chinese People’s Political Consultative Conference] revealed economic targets that are largely in line with market expectations. Market sentiment has bottomed with a gradual U-shape recovery,” she says.

In another way, a report by Nikko Asset Management’s Asian equity team noted: “There are a large number of Chinese companies with attractive growth profiles that are being penalised by the country risk.”

And despite severe difficulties, Chung says China’s A-share market – those listed on the Shanghai or Shenzhen stock exchanges – is now in a decent place. “The A-share market has stabilised, thanks to the national team’s buying support – albeit at a slower pace – and to stricter controls on quant funds and the banning of short-selling in some areas,” she says.

“Foreign inflows have also started to come back. Company earnings are bottoming. Momentum and macro data are improving,” Chung adds.

All together an argument that presents investment in China as a positive move over the long term.

Five themes

Expanding on his case for China, Chui lists five themes that investors would be wise to keep in mind when looking at the country.

The first, he defines as a supply chain theme. “Increasingly, China is becoming more vertically integrated. Moreover, China’s supply chain solutions are becoming more sophisticated,” he says.

Second is the much discussed topic of sustainability, an area even advocates of China have been reluctant to talk about. But Chui offers a different narrative. “China is at the centre of providing a myriad of sustainability solutions, not just for itself, but also for the world,” he says.

The third he defines as services. “China has a population of 1.4 billion, which creates a huge opportunity for the services and consumption sectors,” he says.

Fourth is the issue of savings. “China has always been a savings economy which allows this untapped potential to have a multiplier effect on the economy when unleashed,” he says.

And the fifth theme is what Chui categorises as systems. “China has historically relied on imported systems to power its corporates and industries,” he says. “That is changing rapidly as numerous domestic suppliers have shown that they have equally compelling support systems.”

Muddling through

But Shamik Dhar, chief economist at BNY Mellon Investment Management, believes that a muddle through scenario is the most likely one in China. “This is characterised by weakening growth bottoming out, no further major sanctions, but targeted actions aimed at de-risking, and growth that eventually eases to a yearly average of about 4% in the second half of the decade.”

Which, at least in terms of growth, is quite an upbeat muddle-through scenario.
 Also looking at things a little differently and evaluating opportunities in China is Liliana Castillo Dearth, head of emerging markets and Asia equities at Newton Investment Management, who says it is important to understand a new playbook when approaching China.

“While the last decade was about the wealth creation of the top 20% tier, the policy focus has now shifted to the remaining 80%,” she says. “Consumers in the lower tier are more focused on value for money and, in a way, less brand-oriented versus higher-tier consumers.”

In terms of sector preferences, her view is to be selective on consumer exposure, with a preference for companies that are addressing demands of lower-tier consumers. “We are also focused on services taking incremental wallet share, especially in older cohorts,” she says.

“We are selective on industrials and focus on opportunities driven by self-sufficiency needs or global competitiveness, with  the right balance of quality and price,” she adds. “We also see opportunities given the re-allocation of savings, for example, from real estate to insurance.”

The real world

And what of the argument that China as a long-term investment has had its day?

“If one believes China still has a role to play in the real world – for example, in the clothes we wear, in the cars we drive – then China remains relevant,” Chui says. “It is difficult to envisage a world where China is cut off from the supply chain. Not only will it be expensive to do so, it will also be impossible to do so without sacrificing quality and larger goals such as climate change.”

Moreover, the Chinese economy in itself is large and unlike any other given that it is able to supply a lot of what it needs by itself. “The investment case for China is probably stronger than before but at the same time, is different from what China used to be – a factory for the world,” Chui says.

Although it is worth noting that it has been replaced by other emerging markets in this respect. “Given that China’s domestic economy story is unique, it serves as a good diversifier from a portfolio construction standpoint. As a result, China can be viewed in conjunction with other geographies,” Chui says.

But away from China, the strong demand for artificial intelligence (AI) and the recovery of non-AI tech continues to be a theme in Asia. “Especially for the tech-heavy markets of Korea and Taiwan,” Chung says.

She adds that high-quality debt is tempting. “Asia investment grade bonds continued to attract inflows due to their attractive yield levels and negative net issuance.
 “Credit spreads remain stable at already tight levels,” she says. “US treasury yields are likely to stabilise around the current levels, given the market has adjusted its rate cut expectation to be more realistic. Asian investment grade bonds will remain stable, mainly for carry.”

Dhar also points to other areas in the region. “For allocations ex-China, we favour the Taiwan-Korea equity complex which reflects a bottoming out of the tech cycle, led by semis and driven by a pick-up in AI-related demand,” he says.

“Taiwan and Korea have also been decoupling from China for a while now, even preceding the imposition of tariffs and exported investment-controls by the US and EU. We also like Japan and India and suggest ‘neutral’ in both places for now as we are wary of policy-driven headwinds – Bank of Japan normalisation – in the former and frothy valuations, relatively high price-earnings, in the latter.”

Perennial debate

Although Jian Shi Cortesi, investment director of Chinese and Asian equities at GAM Investments, says that the region is not necessarily a fight-off between China and its neighbours.

“The perennial debate over whether India or China will emerge as the ultimate winner oversimplifies the intricate dynamics of global economic growth,” she says. “Why must it be a zero- sum game? History reveals that when one nation rises economically, it need not come at the expense of another.”

Adding to the point, Cortesi says: “The US ascended without diminishing the UK’s prosperity. Both co-existed, contributing to global progress. Japan’s economic growth did not harm the US. Instead, it catalysed global expansion.

“China’s rapid GDP growth did not come at the expense of other countries. It fuelled economic expansion worldwide. Rather than framing this as a zero-sum game, we should recognise that India and China can co-exist harmoniously. Their unique strengths contribute to global prosperity.”

Chung ultimately says there are reasons to be positive about China. “We are cautiously optimistic about the prospects of Chinese equities and anticipate a more pronounced market recovery in the second half of the year,” she says.

The current 12-month forward price-earnings ratio for the MSCI China index is 10.2x, Chung says, with trading almost one standard deviation below its 10-year average. This is leading to under-valuations. Hong Kong equities are experiencing even more significant undervaluation, with the Hang Seng index sporting a 12-month price-earnings ratio of 8.8x, equivalent to two standard deviations below its 10-year average.

“Assuming no substantial revisions to earnings and a return to long-term valuations through mean reversion, this scenario could result in an approximate 20% upside for the MSCI China index and a 30% upside for the Hang Seng index,” Chung says. “This creates an attractive entry point for long- term investors and acts as a safeguard against further significant downside risks.”

It therefore signifies that China, despite all the recent noise, has still much to offer institutional investors.


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