Having outperformed other regional stock markets for much of the pandemic, Chinese stocks have fallen sharply over the past few months (Exhibit 1). Concerns around the Chinese economy slowing were blamed for the initial move, but more recent declines have been triggered by regulatory tightening focused in specific sectors. This piece sets out why we remain positive on the medium-term outlook for Chinese assets, although we recognise that it may take some time for the scope of regulatory tightening to become clearer before sentiment towards the stock market improves.
Exhibit 1: Chinese and developed market equity returns
Index level, rebased to 100 in January 2020
How should investors interpret the latest regulatory changes?
Recent moves from policymakers are best understood in the context of Beijing’s efforts to balance short-term growth against longer-run policy objectives.
In the technology sector, Chinese regulators are taking steps to address inappropriate use of market power, limit regulatory arbitrage opportunities and increase market competition. Cybersecurity is another emerging focus, with companies’ treatment of user data receiving particular attention. There are clear parallels to regulatory actions witnessed in developed markets in recent years. Companies that have chosen to pursue overseas listings – often Chinese technology names trading on US exchanges – are also coming under additional scrutiny and may be particularly vulnerable to future rulings. While broadly we are seeing technology regulators take a more active stance, we do not believe it is in China’s strategic interests to punish its domestic champions, particularly in the context of the longstanding US-China rivalry. Instead we think regulators want to ensure that technology giants are competing with the next cohort of innovators in a fair and well-functioning market.
The education sector has also seen significant regulatory changes. The Chinese government will no longer approve the setup of new private tutoring companies, and existing companies which tutor the school curriculum will be required to transform into non-profit institutions. While private sector tuition remains discretionary in most western countries, after-school tutoring has become so pervasive in China that authorities now view it as a key social policy challenge. The latest measures are designed to alleviate both the mental burden of extra tuition on students and the financial burden for parents, with a view to stemming the decline in China’s birth rate over time. In this context, we do not expect that the severe actions taken in the education sector will become widespread across the private sector.
The tone of recent policy interventions has highlighted that Beijing is keen to ensure that corporate behaviour remains aligned with the administration’s long-term policy goals. That said, we do not believe this represents a fundamental shift in another key long-term objective: to open up Chinese markets to foreign capital. Substantial efforts to integrate both Chinese equities and bonds into international indices are ongoing. In our view, policymakers will be acutely aware that they do not want regulatory actions to undermine the attractiveness of Chinese assets to the global investment community.
What do we expect next?
The Politburo meeting at the start of August provided greater insight into the economic and regulatory policy direction for the rest of the year.
Further reforms are still on the cards for some of the ‘new economy’ sectors where the Chinese authorities wish to achieve better social outcomes or improve the competitive environment. Regulatory uncertainty will remain elevated until the scope of reforms becomes clearer, particularly for politically or socially sensitive industries. It is important to recognise, however, that many of China’s new economy leaders will still have room to chart future growth; they have been working closely with the government for many years and will continue to do so.
There will also be sectors that benefit from future policy changes. Examples include climate-focused technology to support greenhouse gas reductions, industries related to accelerating the rollout of electric vehicles, and sectors critical to achieving self-sufficiency within key parts of the technology supply chain.
From an economic perspective, the Chinese government recognises the imbalances in the economic recovery, with small and medium-sized enterprises and low-income households having lagged to date. As a result, targeted fiscal stimulus is likely to be preferred to monetary policy in supporting growth for the rest of the year. Monetary policy has shifted to a more neutral stance following modest tightening in the first half of the year, although further easing is possible if growth momentum continues to fade. Broadly, Beijing appears to be fine-tuning growth back on to a more stable path, having gone through the “boom phase” of its recovery last year.
The impact of the spread of the Delta variant remains something of a wildcard. The Chinese government was highly effective at stemming the spread of previous variants, but cases have been on the rise again. Vaccine rollout is proceeding at pace, although real-world studies of the efficacy of different vaccines remain limited. This will be an issue to watch closely over the coming months. We don’t expect a repeat of the sharp slowdown witnessed in the Chinese economy last year, but given China’s desire to pursue a “zero-Covid” strategy, there is a risk that restrictions will be applied periodically. This could well have knock-on impacts in the global supply chain; recent shutdowns linked to Covid-19 in Ningbo-Zhoushan – the world’s third busiest port – are a prime example.
What are the investment implications?
The sharp declines over the past few months have served as a reminder that Chinese equities do come with a higher level of volatility than many other markets. Over the past 25 years, the annualised return from the Chinese stock market is over 5% in local currency terms, despite average intra-year declines of close to 30%. Calling the bottom of any market correction is an impossible task, although valuations have now fallen substantially, from over 18x 12-month forward earnings at the peak earlier in the year to below 14x today for MSCI China. While valuations may remain under pressure until the markings of the regulatory playing field become clearer, ultimately, we expect investor attention to gradually return to company-specific fundamentals.
In our view, Chinese assets remain an essential part of both global equity and global bond allocations. Beijing has made a huge push to open its capital markets to international investors, and we expect this to remain a priority. Short-term volatility has not fundamentally changed the long-term investment opportunity in China, which is based on technological innovation and the rise of the domestic consumer. The key for investors is to access the Chinese markets in the right way: via a diversified portfolio of both onshore and offshore companies and with an active approach that can differentiate between the winners and losers of the government’s long-term policy goals.