Investors in Chinese equities will be glad to leave behind 2020’s Year of the Ox, although the New Year might not be a completely fresh start.
The past 12 months have been a struggle for China, which is currently subject to rolling regional lockdowns as it targets a ‘Zero-Covid’ policy, an agenda proving disruptive to its financial and economic recovery.
This comes on top of a widespread energy crisis, regulatory crackdowns on technology and healthcare companies, and the fallout from the Evergrande scandal, an event which sparked debt contagion fears in the now heavily weakened property sector. All of this has culminated in a significant outflow of overseas investors from the market.
To cap it off China’s economy – the second largest in the world – is showing signs of weakening growth, with GDP expanding just 4% in the final quarter of 2021, the slowest growth rate in 18 months.
At the end of last year the IA China/Greater China sector ranked second worst overall among all investment association (IA) sectors, with the average fund losing 10.7%.
Source: FE Analytics
The upcoming 12 months is the Year of the Tiger, which according to Chinese astrology symbolises being brave, competitive, confident and displaying great levels of willpower. The latter of those characteristics might be especially important for investors this year.
Anti-trust regulation
Many of China’s new policies on anti-trust behaviour have been disruptive and painful in the short term and have formed part of a shift towards more sustainable long-term growth rather than growth at any cost.
This was evident from China’s monetary policy, which has moved from chasing exorbitant growth to a more gradual process, cutting interest rates and gradually rolling out monetary easing.
Baillie Gifford’s Roderick Snell and Sophie Earnshaw said this long-term focus “may not be a bad thing” but acknowledged that it would be hard to deal with in a market that is looked at more in the short term. “Changes to quarterly earnings and negative news flow are likely to be met with selling pressure”, they said.
These anti-trust policies are a great example of this, focused on narrowing the widening wealth gap in China and reining in the billionaire owners of its biggest companies. While this is idealistic in the long-term, it caused an immediate, negative reaction from investors.
Now the worst may be behind us on this front, according to Ninety One’s Charlie Dutton, and the policies could be beneficial to global markets in the long run by providing some clarity on what to expect when other legislators develop their own anti-trust rules.
“As near-term regulatory noise fades, the long-term drivers of structural growth come back into focus. These trends – among them, rising wealth and the expansion of the middle class, digitalisation and China’s push for self-reliance in certain tech sectors – remain intact and continue to be tailwinds for select Chinese firms,” Dutton said.
Covid-19
China is still battling a lot of its old demons despite its New Year resolutions for change. Covid, for example, continues to a be a headwind to equities as the Communist party maintains its out-of-step approach to the virus.
Carlo Liao, China economist at PIMCO, said the government would likely stick to its zero Covid cases mantra, despite the increasingly higher economic and social costs.
China has rejected using the provenly effective MRNA Pfizer-BioNTech and Moderna vaccines and endeavoured to develop its own, with limited success. Liao said a change in its Covid policy could either be a breakthrough in treatment or more concrete conclusions on the low fatality/hospitalisation rate of Omicron. However any changes to policy would likely occur after the 20th Party Conference in October.
Geopolitics
Another risk to watch out for is renewed geopolitical tensions with the US, which could impact equities. Darius McDermott, managing director of FundCalibre, said this was one of the main risks facing China currently, having emerged as a big challenger to the US.
“It’s not going down well – the US is starting to put more pressure on China in terms of trade wars and trying to isolate it economically to weaken its power,” he said.
The upcoming Winter Olympics is likely to be a source of even more tension, with the US, UK, New Zealand, Canada and other countries announcing a political boycott of the games in protest of human rights violation in China, which Beijing strongly denies.
What does this all mean for investors?
The swirl of negative headlines has caused a marked decline to equity valuations, creating a lot of investment opportunities, according to Fidelity’s Dale Nicholls, particularly the companies with lower regulatory risks that were caught in the crossfire.
Dale, manager of the £1.6bn Fidelity China Special Situations trust, said smaller companies were now offering particularly appealing valuations and will be “long-term beneficiaries of regulatory action in areas like anti-trust”.
Wenchang Ma, manager of the Ninety One All China Equity fund, said she was focusing on stocks involved with the energy transition, IT and utilities and materials, the latter of which are on heavily discounted valuations after being tainted by the property sector saga.
For investors considering an allocation to China, McDermott highlighted three funds: Allianz China A-Shares, Guinness Asian Equity Income and Aubrey Global Emerging Markets Opportunities.
The former offers more direct exposure to Chinese equites, investing purely in the Chinese A Shares market “which is very large and very inefficient, providing great opportunities for active managers”, McDermott said.
The others provide a broader exposure to emerging markets as a whole, providing more of a cushion from any China specific volatility.
But investors should proceed with some caution. Jason Hollands, managing director of Bestinvest, said that many investors were likely “lured into China funds by the spectacular gains of 2020” but warned them to be considerate of the high risks when using country-specific emerging market funds as small satellite holdings.