China equities have experienced mixed performance so far in 2021, with increased evidence of tapering, heightened regulatory oversight, US-listed liquidations and credit events. GAM Investments’ Rob Mumford explains why he is increasingly positive despite the likelihood of ongoing volatility as recovery meets a tighter policy environment.
China’s equity market has been held back year-to-date by a series of marginal negatives. These include diverse events such as the start of policy withdrawal, industry reform and regulation, accelerated capital expenditure within the internet platforms (pressuring earnings), a family office liquidation, cool US relations and credit stress. We sounded a note of caution in late January, highlighting that a strong top-down outlook was accompanied by both top-down constraints (high leverage driving a need to taper) and bottom-up issues (exuberance in liquidity / valuations). We remain confident in our positive full-year return expectations, primarily supported by strong GDP and earnings growth. Meanwhile, stock volatility is providing what we consider to be attractive entry points into specific sectors and companies, particularly when compared to international markets.
Policy withdrawal – a controlled release of excess air, not a puncture
President Xi hosted a politburo meeting on 30 April. While the key message was no change, an emphasis on “house cleaning” in the form of supply-side reform and prevention of financial risks likely implies a continued modest tightening first signalled in mid-January. Tapering has started earlier than other regions, driven by normalising economic conditions and a necessity to keep leverage under control. Stabilising monetary and fiscal aggregates will generate a negative policy pulse; while this is a marginal headwind it should not stop China generating world-leading GDP growth which perhaps has further upside given the various US stimulus plans. Recent revisions to GDP have been to the upside and although the leading internet platforms have seen downwards earnings revisions, earnings have been on a positive trend outside of this sector. The authorities have made it clear that policy will remain flexible, targeted and counter cyclical. These intentions can work both ways and with an “uneven” recovery underway we would not be surprised to see selective easing moves, including a potential prime loan rate cut, reserve requirement cut and accelerated green bond issuance if growth starts to undershoot.
Chart 1: Forecasts for China GDP – edging up despite the start of tapering
Chart 2: China leads the earnings per share growth versus region over 2021 / 2022
The authorities kept monetary and fiscal conditions much looser than they would have liked during Q4 2020, though did start to refocus on a key third leg of policy control – industry reform. As economic conditions have normalised, rather than head into another round of deleveraging, as happened in 2018, the focus has remained on supply-side reform and the latest politburo meeting confirmed this intention. The initial and continued focus has been the property sector (in itself a key policy tool), though it is the internet platform arena which is now a key area of focus, where regulatory oversight is moving from a “sand box” environment towards more specific guidance and restrictions on how to operate.
The early stages of increased internet platform supervision
While we have a positive long-term view, we see three overhangs near term on the large internet platforms under scrutiny. First, the new antitrust regulatory umbrella remains an uncertainty, particularly in the areas of separating business lines and customer data collection. We do not see visibility on the various factors in play becoming clear in the short term; therefore the restrictions, guidance and fines imposed so far cannot with certainty be deemed the end game. Second, most large platforms have stated an intention to engage in an accelerated investment cycle, most notably in the area of community purchase, which is leading to significant earnings downgrades at a time when the year-on-year comparisons to a high Covid-19 impacted base were going to be a challenge. Finally, while we think domestic nominal and real rates are likely to remain stable, we see upside risk to trends in US rates, particularly over the second half of 2021 which may also be a negative for long duration equities including some of these large platform names on high valuations.
Chart 3: Internet platforms dragging down positive earnings trends from IT, financials and industrials
In contrast, outside of these platforms there is both online and offline retail exposure which we find attractive. A promotion of high-quality consumption is the primary policy goal of China’s new Five-Year Plan while the base of comparison (outside of pure online retail) is also much easier. Even in the online space a number of names suffered significant drawdowns in March, blamed on the liquidation event at a large US-based family office, which is presenting attractive valuation entry points.
Deep value with catalyst
Supply-side reform has extended beyond the internet names to include deep value areas of the market. As a key policy lever, property has remained an area of elevated scrutiny since Q4 2020 while insurance reform has been ongoing since 2018. In both cases we see the reforms as long-term positives, particularly for larger, well-funded operators, those poised for a cyclical recovery and names underheld by investors due to market conditions last year, where strong growth stocks prevailed. These sectors fall into the deep value category and in some cases, trade below global financial crisis (GFC) valuations.
While value has done better this year, another recent credit event has led to a consolidation in credit-sensitive equities, including property and insurance. Shares in China Huarong Asset Management were suspended at the end of March due to reporting delays and pending a clarification on its accounts. The issues surrounding this company are not surprising given charges laid against a previous chairman. Even so, as a former triple A-rated credit with USD 22 billion outstanding offshore debt and operating directly under the ministry of finance, the situation is being monitored with interest while the company’s bonds have experienced significant volatility. In 2020 we saw various frameworks used to deal with known companies in difficulty and if a review of the accounts reveals a more challenged position we would expect this situation to be handled in a similar fashion without causing systemic stress. Therefore we see recent weakness in credit-sensitive equities relating to this issue as an opportunity with sectors including insurance and property trading in deep value territory.
Chart 4: Current year price-to-earnings ratio for China real estate sector
Chart 5: Current year price-to-earnings ratio for China insurance sector
While meetings in March 2021 between US and China representatives in Alaska illustrated that the relationship remains cool, it was interesting to observe that even following a strong rebuke from China regarding a joint statement from Japan and the US regarding the South China Sea, a few days later President Xi agreed to join a US-sponsored climate meeting. In May, the US also agreed to join a United Nations event chaired by China on global cooperation. These are just two examples which, for now, strengthen our view that while the US-China relationship is likely to remain difficult, it will be issue-based with certain areas more contentious than others. While tension in the relationship looks set to be an ongoing feature of global geopolitics at present from an equity risk standpoint, we see less of a threat versus the era of the Trump presidency.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.