A look ahead at new China opportunities created by volatility

Geoffrey: Policy and regulations in China often come in cycles. After the initial shock of a new regulatory cycle in 2021, I think we are past the most intense period. In 2022, companies are adjusting to the current environment and market valuations are already discounting the policy impact. That said, China is just starting to shift its policy to account for the slowdown in economic growth, and we are seeing some green shoots as a result.

Hayden: Last year’s regulatory changes are part of the scene setting for China’s next five-year plan, to be presented at the National Congress later this year. There’s usually quite a bit of intensity at the start of implementation, but I think the details will get ironed out. The economy has decelerated as it adjusts, which is why we expect some buoyancy for the bond market before it bottoms out and moves on to the next growth phase. In fact, the government is pivoting and refocusing its message on supporting a growth trajectory under the new regulatory regime.

Jia Tan: Large internet companies had a tough 2021 as investors focused on regulatory risks and weaker economic growth weighed on company fundamentals and financial positions. While we think the worst has passed, we are conservative in our outlook as sector headwinds remain and it could take time for fundamentals to recover. We don’t look at tech a beta opportunity; we want to be selective and pick long-term winners with intact competitiveness and a clear catalyst in the near future.

On the other hand, we see last year as a significant year for the property industry. After the boom cycle of the last 20 years, we believe consolidation will accelerate and private developers will play a reduced role in the coming years. Shorter term, local government reform efforts should continue, leaving highly leveraged companies in an unlikely position to survive in the more regulated environment. We expect to see the central government adopting more encouraging policies after those efforts. There should be light at the end of the tunnel.

Hayden: To understand what’s happened in the property sector, it’s helpful to bring it back to demographics. China is encouraging people to have more children against an aging population, and high housing prices and income equality are standing in its way. The real estate market has been overleveraged for a long time and it makes sense that the country is addressing that through policy.

From a creditor’s perspective, the changes are great news. The government’s corporate debt ratio mandate—first corporate balance sheet level involvement of a government—requires property developers to take down their leverage and adjust their business models. They will likely end up more like traditional real estate investment trusts (REITs) that we see around the world today. From an equity perspective, we will probably see less of that bull market phase. Today the top 50 private property developers control 70% of the market, and that’s likely to retreat. State-owned enterprises or joint venture partners could become bigger participants, as well as more investment grade and less-leveraged firms in the property sector going forward.

Geoffrey: A more complex regulatory environment is not enough of a reason to walk away from investing in one of the world’s biggest economies and equity markets. Not only sourcing the largest number of initial public offerings (IPOs) alongside the U.S., China is already home to the most engineers and the most STEM graduates globally—and set to dominate many technology-focused industries.

Geoffrey: A more complex regulatory environment is not enough of a reason to walk away from investing in China—one of the world’s biggest economies and equity markets.

Jia Tan: The long-term case of investing in China is still sound. We suggest investors be contrarian in the face of a bear market. After all, the strongest returns have come right after the most challenging years such as 2008, 2013 and 2018.

Hayden: In terms of the corporate bond market, faster court proceedings and a more proactive enforcement of rules and regulations are moving the market closer to international standards., which is encouraging. With a tectonic shift from loan markets to bond markets in China, the local government bond market is now larger than the sovereign bond market. As bond markets become more important, it is moving more private-owned firms into corporate credit market, which we believe will be the size of the U.S. market in the next five years and present many investment opportunities.

It’s also worth calling out the Wealth Management Connect, a cross-boundary scheme that for the first time allows eligible mainland Chinese to invest overseas via Hong Kong-domiciled funds. While the scheme has only started recently and has a quota, it facilitates the two-way capital flow between China and global asset markets and bodes well for the case of investing in China.

Jia Tan: The Wealth Management Connect and last year’s financial reforms are key for relative value investors. We use short selling as a risk management tool to protect our long positions but have always been limited by the availability of short borrowers. The implementation of the new rules would allow us to reach out to domestic investors such as domestic mutual funds, life insurance companies and corporate investors—doubling the size of the pool could mean a five times growth when the market matures in the long term. We can provide valuable diversification to the Asia market.

Jia Tan: A relaxation on the limitations of short borrowing is great news for relative value investors. Doubling the size of the domestic investor pool could mean a five times growth when the market matures in the long term.

Geoffrey: Opportunities can follow a big correction in the stock market. The common prosperity theme aims to increase middle class income, and therefore we see opportunities in consumption, particularly companies that are targeting that demographics. For example, we like the dairy space, which is undergoing a lot of consolidation. And while appliance companies have been hurt by their correlation to the housing market, we still see upgrading demand to increase as incomes grow. We continue to like the health care and financial sectors, as well. Regulations continue to be a concern for health care, but those stocks have been sold down quite a bit already. Similarly, some financial names have become very cheap.

In the short run, internet companies will likely continue to face earnings headwinds because of the new regulations and the slowing economy. But some of them have become inexpensive especially compared with the U.S. tech giants. The government is supporting the semiconductor sector and there are some opportunities, but we have to watch for the right stock prices. Technology is very much a stock picker’s game rather than the beta of the market overall.

Hayden: We are focused on interest rate-sensitive bonds for the first part of this year. The credit impulse, or supply of credit to the market, is likely to bottom out in the first or second quarter of this year, and then start to pick up. That would make us a little bit more bearish on bonds in the second half of the year.

Once the credit impulse starts to bottom out, there is typically a delay of 10 months. In the stock market, we watch one of the largest banks in the world and the blood supply of the Chinese economy and use it as a bellwether. When that bellwether stock starts to also pick up, it is a sign in conjunction with the credit impulse that things are starting to look better.

Another way to execute on this theme is in the U.S. dollar credit markets. Investment grade markets in the U.S. and Europe are near all-time tights, as are the high yield markets. China high yield is the only beaten-up asset class, maybe besides Latin America.

This could be the time to start getting into China high yield securities, and in particular property. The market is already pricing in 50% default rates. Unless one believes default rates would go beyond 50%—which we find very hard to believe—this looks like an opportunity to start allocating.

Hayden: The China high yield property market is already pricing in 50% default rates. Unless one believes default rates would go beyond 50%—which we find very hard to believe—this looks like an opportunity to start allocating.

The reason Asia high yield looks attractive is because of China and Chinese property. Therefore, investors who are in Asia high yield may wish to consider shifting into China high yield as a means of expressing more pointed exposure.

Looking at the macro picture, China’s trade surplus is back to its all-time highs, and we believe the renminbi will remain strong. We also have bond market inflows, equity market inflows and multinationals. The current account is very strong. Interest rates are high relative to most developed markets. The renminbi is a high carry currency in the 2%-3% range today.

Geoffrey: Policy risk obviously continues to be a significant one. As China’s priority changes to more balanced growth and higher quality of growth, rather than quantity of growth, it will mean a different shape for the economy. Companies are adjusting to the current environment and the process could deliver new winners and losers. Those that rely on unbridled funding from the capital markets may have some issues.

Geoffrey: Companies are adjusting to a different shape of the economy. The process could deliver new winners and losers.

We are keeping an eye on continuing tensions between the U.S. and China, particularly with regard to potential regulations or sanctions on certain industries. But we are also paying close attention to valuations. China, just like many other markets around the world, has had a high level of retail participation in recent years. Retail investors tend to be less sensitive to valuations, driving up sectors such as biotechnology and electric vehicles. We are careful to avoid overvaluation notwithstanding good fundamentals.