04 February 2021
In a Q&A, GAM Investments’ Rob Mumford discusses China capital market reform, the possibility of Chinese shares being de-listed in the US and his outlook for the market.
Will authorities address exuberance in China’s equity markets given the focus on sustainable capital market development?
Capital market reform was a key feature of China’s last five-year plan and will remain a key part of the next (five-year plan). It was interesting that even at the apex of the US-China trade war, ongoing reform included increasing foreign access to key financial segments. Further support has come from an encouragement of innovation across technology and healthcare in the establishment and promotion of an exchange for earlier stage companies (called the STAR board) and more recently permission for increased equity allocations for institutions including insurance companies. The drive for broader capital markets, particularly equity markets, is designed to encourage an equity culture (as opposed to debt dependency). To create an equity culture the authorities will want to ensure bubbles do not form and disrupt the stable progression of the market. The pulling of the Ant Group initial public offering and focus on anti-trust reform at the large internet platforms confirms that Chinese authorities are willing to take tough decisions for the sake of a more stable long-term outlook. We would not be surprised to see steps taken to encourage a cooling of the market.
With US-listed Chinese stocks potentially facing de-listing, should investors be concerned regarding American depositary receipt (ADR) exposure?
In our view, no. The majority of large Chinese companies listed in the US already have Hong Kong listings and if they cannot abide by US disclosure requirements (or more companies are sanctioned due to military links) Hong Kong can become the primary listing with a minimum of formality (or in the case of the China telecom companies, the primary listings and liquidity pools were already in Hong Kong). With a secondary listing in Hong Kong, investor positions are fungible which means a holding in a China US-listed ADR can be exchanged for the Hong Kong listed position for a small fee.
Companies without a Hong Kong listing are also likely to go down this route even without a regulatory push as it provides access to Asian liquidity (particularly those without the ability to invest in the US) and liquidity from mainland investors investing via the Southbound stock connect scheme into Hong Kong. In the interim, and for those smaller companies where the cost of a Hong Kong listing might seem more of a problem, the current legislation which could lead to a potential de-listing (aside from companies deemed linked to the military) gives a three-year window for conformity or negotiation.
Should investors focus on domestic China shares or Hong Kong listed stocks (or China US-listed securities)?
A confluence of factors have led Chinese authorities to keep their feet on the liquidity pedal for much longer than they would have perhaps preferred. This has led to pockets of exuberance in the domestic China market and increasingly in Hong Kong listed shares, particularly among popular thematics. This is in stark contrast to the repeated statement of avoidance of floodgate irrigation (following which is drought), excess leverage, a sustainable level of liquidity and the avoidance of bubbles. A January surge in Southbound flows (one third of the full-year 2020 net inflows has occurred in the first 20 days of January 2021) is evidence of strong excess domestic liquidity seeking a home. Three key directives stemmed from the December economic working groups, two of which have played out (de-leveraging motions targeted at the property sector and anti-trust against fintech). The third was to ensure an avoidance of bubbles and there is increasing evidence that such a state exists.
History is not kind to the short-term price action of A-shares or hyper growth valuations when such bubbles are targeted, which in this case comes at a negative inflection point of China credit and policy cycles. Exciting innovation, technology and policy-led growth keeps the medium- and long-term investment case intact, but investors should be aware of the near-term risks (and opportunities if a correction occurs) and the potential for a recovery in performance across a broader range of investment styles (offering attractive relative value).
We favour exposure to a blend of exchanges with a focus on portfolio construction (beta awareness) and a blend of styles (growth and recovery) in businesses with clear competitive edges and sustainable credit profiles. From a short-term perspective, we would urge caution in adding to new extended A-share positions. It is a retail dominated market (estimated at up to 90%) and when corrections occur they can be aggressive while the Hong Kong market remains dominated by institutions and typically offers less volatility from a domestically induced consolidation. The A-share market is a broad and deeply liquid market offering significant alpha opportunities but we would only suggest increasing A-share exposure into any correction and particularly in the event excess retail de-leveraging occurs. Given policy room (both monetary and fiscal) and a focus on stability we believe market downside is likely to be limited.
What is our near and long-term outlook?
We frame our positive view on China around four pillars; premium growth rates, the firepower to sustain growth, improving quality of growth and reasonable valuations. We believe that recovery trends supported by ongoing global stimulus, vaccine rollouts, plus reform-led growth (with the new five-year plan), make the top-down outlook for China as good as ever. However, elevated liquidity support has driven valuations in certain pockets of the market to extreme levels. This comes at a time of a likely inflection in the China credit cycle and near-term prospects of fiscal and monetary ‘policy cliffs’, plus potentially more forceful drives to address moral hazard in the equity market. In other words, the bottom-up quality of the market and (specific) valuations near term have deteriorated. There is a risk of a market consolidation but given the very strong top-down outlook and longer-term positives, this should provide opportunities among sustainable high growth businesses (technology at the right price, select internet platforms), renewable growth (selectivity within electric vehicle supply chains, wind, solar), recovery with a cyclical bias (travel, casinos), value cyclical (insurance) and materials (advanced raw materials).
There is a tendency for investors to be overly concerned about China equity risks when valuations are attractive yet to forget the same challenges when valuations are relatively expensive. With virus aftershocks recently rising in China, the timing of action to reduce exuberance may be pushed out slightly but we believe the issue of excess levels of indebtedness (and excess liquidity) is a near and present danger that needs to be addressed. The issue of moral hazard across China’s credit markets has gradually been addressed (ie via allowance of defaults) as an essential aspect of capital market development. In order to create a sustainable equity culture in China, a similar exercise needs to occur in the equity markets. In our view, this could present opportunities among longer-term fundamental (quality premium growth) and technical (increased representation in global equity indices) areas of the market. The second leg of our four-pillar view remains very much in place and we feel the broader market downside is fairly limited with various tools available if trends become too negative. With inflation falling significantly of late, one area that could provide support to the market is a potential loan prime rate cut. Real interest rates have been climbing steadily and while the impact of interest rate shifts can be limited, this would certainly boost sentiment.
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 no 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.