While developed markets have borne the majority of negative headlines this year as they grapple with an energy shock and rapidly rising interest rates, the news from the Asia Pacific region has also been challenging, with much of this down to China.
Its strict zero-Covid policy has meant that lockdowns have been prevalent, weighing on domestic demand. In the property space, there have also been several bond defaults from stretched developers over the past 18 months, creating unwanted headlines for the sector.
Meanwhile, ongoing tensions with the US have seen Taiwan taking centre stage in relations between the two economies earlier this year. The US has sought to protect and grow its market share of semiconductors through the CHIPS Act and restricting Nvidia from exporting its flagship artificial intelligence (AI) chips to China, aiming to dent Beijing’s AI ambitions.
Compounding this volatility, Chinese economic data has been less than stellar, with China implementing additional stimulus measures to support its recovery, such as lowering key lending rates, offering new credit via state-run banks and by reducing the amount of cash that banks need as reserves.
Three key sectors
With these tensions unlikely to disappear following the forthcoming 20th National Congress, given that Xi Jinping is all but assured of a third term at the helm, the past reliance on the “Starbucks approach” to gain exposure to China through investing in multinationals with significant China revenue exposure is no longer feasible.
Instead, investors should directly allocate to high-quality domestic companies, in our view. Such businesses can continue to compound their earnings in the face of market volatility, supported by long-term structural growth drivers.
We see three main sectors that are supported by structural growth drivers in China and should continue to be able to ride out the broader market noise: consumer, healthcare and information technology.
The consumer sector’s growth is driven by the increasing population size and changes in people’s spending preferences. China is benefiting from a significant rise the middle class, with a population similar to the size of France joining the middle class every two years.
Currently, the number of citizens that fall into the cohort is greater than 700 million. Furthermore, younger consumers are integrating more traditional Chinese culture and style into their buying habits, at the expense of foreign brands, a trend known as ‘Guochao’.
An ageing population
There are several structural growth drivers supporting the development of the healthcare market in China. Firstly, the ageing population will increase the demand going forward for healthcare services.
This is supported by regulatory tailwinds that are increasing access of medical drugs/devices for patients, improving access to higher quality hospitals and supporting med-tech development.
Volume-based procurement (VBP) has reduced the cost burden of drugs and devices on underlying patients and the reduced margin on generic drugs means that pharma companies are spending more on pharma R&D and innovative drugs.
Equally, following the National Health Commission’s basic facility standard and services requirement published in 2016 and then the 14th five-year plan post Covid, the stage is set for enhancing medical equipment within various hospital departments and a focus on increasing the quality of hospitals across the country.
Finally, the healthcare market will benefit from increasing penetration and upgrades, which is underscored by the government published guidelines to help increase capacity, as average annual medical expense per capita in China 6.5% of the levels in the US.
Earlier stage tech than the US
The creation of China’s great firewall back in 2000 was established to enable content censorship. As a result, large global tech companies were unable to access the Chinese user base and efficiently execute international expansion. The result is that the landscape of China tech is vastly different to that of the US, where the split between enterprise and consumer software is about equal.
Within China, enterprise software is at a more nascent stage and offers long-term growth potential. The penetration rate of China enterprise and infrastructure software as a percentage of GDP is still far below the levels of more developed countries and there is a positive correlation with GDP per capita.
In our view, these three sectors offer investors a deep pool of opportunities. Due to sentiment remaining negative for a prolonged period, a disconnect has emerged between valuation levels and earnings of high-quality companies, which are typically industry leaders with low sensitivity to the economic cycle and underpinned by strong cashflow generation.
Such businesses have been able to sustain earnings growth in a time where their share prices have fallen. As a result, attractive entry opportunities are prevalent and are set to benefit once the market pivots away from the focus on noise and moves towards company fundamentals.
Charlie Dutton is a portfolio manager of the Ninety One Asia Pacific Franchise fund. The views expressed above should not be taken as investment advice.