Active Thinking

At GAM Investments’ latest Active Thinking Forum, Wendy Chen highlights the key takeaways from China’s Party Congress and considers when we might see China exit its zero-Covid policy, while David Goodman discusses the new leaders in disruptive growth that may emerge from the downturn.

11 November 2022

Wendy Chen, Investment Manager, Disruptive Growth

The National Congress of the Chinese Communist Party (Congress), which took place last month, was arguably the most significant policy event in China for the next decade. This is not only because President Xi Jinping is beginning his third term but also because the current pace of growth in China is the slowest in decades; markets were looking to see what this political event would signify for the economic outlook of the country.

Initially, the market reacted quite negatively to the Congress. Political commentators were very vocal regarding their concerns about the outcome – though the market expected Xi to assume his historic third term, few expected a sweeping victory in of politburo standing committee – the seven most powerful roles in China for the next five years. We believe this outcome initially led to market fear, particularly given Xi’s Common Prosperity focus as well as the policy tightening cycle which occurred in the second half of 2021. However, we regard the event as a tale of two Congresses because the election outcome and the official statement given paint different pictures.

Indeed, if we look at the keynote statement made at the Congress, the outcome was more positive than markets expected, with a very consistent message as per the past two Congresses under Xi’s rule, with good level of focus on the economy as well as private ownership. We did not see the creation of new ideological terms such as common prosperity. What we did see was a pro-growth stance, with innovation, hard technology, rural welfare and green development all keywords. Even within the rising focus on security that markets feared, a good share of the focus was on food security and supply chain security, rather than just military security. Given the election outcome, one could easily have expected a more left-wing statement at the Congress. We believe the moderate statement is quite telling and suggests that some of the ideological moves taken beforehand are less necessary.

The Congress itself is essentially an election and is not focused specifically on policy drafting. That is why, if we look at the historic performance of the MSCI China Index following previous Congresses, for six months to one year it tends to outperform the MSCI World Index. This is because once the leaders are settled into their roles they tend to reel out more supportive economic policies. On the timeline following the Congress, March 2023 will mark the National People’s Congress, which is a key policy drafting event at which the new target for GDP growth over the next five years will be set.

Notably, the Covid-zero policy was not mentioned at all during the statement and as a result, in recent weeks, we have seen much speculation on the policy path. Shortly after the market downturn following the election, China equities made an impressive comeback, with the MSCI China Index up 12% and the KWEB up more than 30% in one week. The trigger for this was rumours on social media in relation to the formation of a committee focused on lifting the Covid-zero policy, as well as speculation that the timeline for reopening would be brought forward. Even after the Ministry of Healthcare gave a statement stating that the dynamics of the zero-Covid policy would not change for now, neither market has given back any of its gains. It is clear that what the market wants is an outlook for reopening. No one really believes the social media chatter but there is growing recognition that existing policies are not sustainable going forward.

In addition, we have been looking at the circumstances on the ground which might lead to reopening in China. The vaccination rate for people aged 60 and over is still low but we have seen it going up quite significantly over the last six months, especially since the Shanghai lockdown. This number is now 67% and if we put this into context, when Hong Kong opened up in October 2022, that number was 80%. Also, mass Covid testing has been a big drag on local governments’ budgets. Going forward, the frequency requirement for mass Covid testing in the provinces will be reduced. We believe then that the groundwork is being laid for reopening. Market consensus is for reopening in March 2023; we think there is a chance that this will happen earlier. The major concern on reopening in the winter is the combination of the flu and Covid variant, leading to a shock to the healthcare system. However, a relatively warm winter is looking increasingly likely, not just in China but across the world, thereby reducing this risk.

We believe the reopening has not yet been fully priced in and that now could be a good time to look at China equities. The MSCI China index is currently trading at below 9x P/E, which is almost two standard deviations below historical average. Even if we attribute a discount for a slower growth and a higher risk profile, we still believe Chinese equities are undervalued. In our view, that is why we have recently seen Chinese markets jump significantly on social media reopening rumours. Over the long term, we are looking at companies that will benefit from China’s policy tailwind, many of which are China A shares, which have outperformed, even during China’s policy tightening cycle. The China A shares market has a large composition of information technology, industrials and hard technology – all sectors that government policy is seeking to support.

David Goodman, Investment Manager, Disruptive Growth

It has been a difficult time for duration assets as the Federal Reserve (Fed) hikes further and faster than at any point in history. Over the third quarter we saw a hiatus in nearly all asset classes. We had a rally of 20% plus, followed by a sell-off in excess of 20%. It has been a volatile quarter to say the least. The Fed has reemphasised its commitment to bring inflation down and is continuing to push that solidly. This has added to the speed and size of sell off that we have seen in financial markets.

Growth equities have taken the brunt of this indiscriminate selling; unprofitable tech that is growing and is coming through has taken some massive hits. It is no surprise that duration equities have been sold down. Macro events have only added pressure to already frazzled markets. The political debacle in the UK, the war in Ukraine and China relations are all causing issues. If we were to drill down into growth or duration equities, the year-to-date numbers have obviously been weak. Within the growth index, we have seen plenty of big companies that are down more than 80% year-to-date. The size of the moves over such a short space of time is typical of chaotic periods where outcomes are based on the larger macro picture, rather than the individual bottom-up factors we look at. Investors so far have been hiding in quality tech but over the last week or two, this has started to unravel. This is interesting because high growth equities are the ones that sell off first as investors transition to more growth at a reasonable price (GARP) names, but high growth equities are also typically the first to come out of downturns. Over the last few months, we have started to see new leaders come through. The high growth sectors such as unprofitable tech bottomed between six to eight months ago on a relative basis, so we are quite excited about what is to come. We are green light on the fundamentals and we are waiting for the technical situation to improve.

With growth investing, it is not about price-to-earnings. Rather, it is about growth and what we are expecting is that the big names such as Google, Amazon or Facebook are no longer going to lead us out of this. They were the disruptors and now they have become incumbents. What we will see is businesses that are going to grow through this downturn and we will start to see new leaders. We think these companies will be more industrial than consumer driven. For example, we expect the new leaders will be in AI or software as a service in industrial businesses that are starting to use technology where software becomes mission critical for them.