Investors should recognize that regulatory changes are not all market negatives.
Chief Market Strategist, Asia Pacific
Following the sharp market correction for both onshore and offshore Chinese equities, many investors are asking how they should position Chinese equities in their portfolios. We believe China remains an integral part of any investors’ portfolio, both in equities and fixed income. The recent Politburo provides more clarity on the challenges that Chinese officials face in balancing the short-term growth trajectory of the Chinese economy with the longer-run policy objectives aimed at creating a much more sustainable economic environment.
Admittedly, the abrupt changes in regulations relating to the technology and education sectors in recent months could continue to influence global investors’ sentiment towards Chinese assets. Regulatory reforms are still on the cards for some of the ‘new economy’ industries where the Chinese authorities see the need to achieve better social outcomes, such as youth protection and appropriate social benefit coverage for workers, or improving the competitive environment by allowing smaller players to compete with industry leaders.
Meanwhile, investors should also recognize that regulatory changes are not all market negatives. For example, ambitions in self-sufficiency in semiconductor manufacturing and software development or in achieving greenhouse gas reduction targets mean certain industries stand to benefit from policy tailwinds in the medium- to long-term.
On the role of international capital markets for Chinese companies, the Chinese securities regulator has called for closer communication with its U.S. counterpart. The regulator has stressed it is open to companies choosing where to list, as long as it is in compliance with relevant law and regulations. This is consistent with the authorities’ narrative that the listing rules related to education providers is an isolated incident.
The Politburo meeting at the start of August, chaired by Chinese President Xi Jinping, provided greater insight into the economic and regulatory policy direction for the rest of 2021. On the economic outlook, the Chinese government recognizes the imbalances in economic recovery. Small and medium enterprises and low-income households have lagged during the current economic recovery. Meanwhile, the latest Purchasing Manager Index , which fell to 50.4 in July from 50.9 in June and is at its lowest point since February 2020, illustrates the broader momentum slowdown in China’s manufacturing base.
This implies that fiscal policy could do more of the heavy lifting in supporting growth for the rest of this year, especially as the 2021 government bond issuance is running below this year’s quota and can be stepped up. Monetary policy has shifted to a neutral stance now, after some modest tightening in 1H 2021. However, this position could also shift if growth momentum eases further.
EXHIBIT 1: THE CURRENT CHINA EQUITY MARKET CORRECTION COMPARED TO MARKET CORRECTIONS IN THE PAST DECADE
On social policy, improving labor rights and incentivizing families to have children could impact the business sector. After all, the after-school tutorial reform was aimed at reducing parents’ financial burden.
On industrial policy, electrical vehicles, greenhouse gas reduction and nurturing scientific and technological innovation to become more independent remain the key focus. This should not be surprising and would remain on the government’s priority in the foreseeable future.
The recent regulatory changes in China should be viewed in the context of finding the balance between short- and long-term growth objectives and that Chinese officials have the tools to do both by utilizing fiscal and monetary policies to stabilize the near-term growth outlook, which creates room for measures to address longer-term economic and market reform. This is something that has become more apparent after the latest Politburo meeting.
The MSCI China Index has corrected by around 26% since February, much of which took place in the past few weeks. In this case, the regulatory uncertainty implies the market sentiment, especially for international investors, could remain cautious for now.
It is impossible to predict the bottom of any market correction, but it is worth looking back to history and observe what this tells us. Exhibit 1 shows the more substantial periods of volatility in the past 10 years. It shows that the current downturn is far from unique in the context of the Chinese market, even though the triggers are different. The correction in 2015/16 was brought by a stock market bubble with excessive retail participation. The stock market decline in 2018 was led by the onset of U.S.-China trade tensions and a drive to de-leverage the corporate sector.
In contrast, the latest economic policy bias is neutral, leaning towards a more supportive position, especially considering the moderating growth momentum and uncertainties from the recent small-scale COVID-19 outbreaks in Nanjing and a few other cities. To unlock the current stalemate, the authorities may need to communicate with the markets more clearly on their policy intentions to allow for the business sector to respond accordingly and allow investors some time to digest the news.
China is still an essential part of global equity allocation, and technology continues to play a critical role in the country’s economic development. Beijing is still looking to open its capital markets to international investors in the long run. Hence, we view the latest episode as a temporary setback, where investors would need to understand Beijing’s policy objective of social equality and actively manage their positions.