China dominated headlines throughout Q3 2021, delivering extensive stock market volatility. GAM Investments’ Wendy Chen examines China’s tightening regulatory cycle and discusses why she believes investing in this environment requires a change of focus towards policy tailwind sectors.
After the Chinese Communist Party (CCP) centennial on 1 July, the bulk of severe regulations held back for this anniversary were rolled out. A precarious dive in Chinese names started with an investigation into Didi after its hasty initial public offering (IPO), one many commentators suggested happened despite government warnings. Panic selling climaxed with the total ban and forced nationalisation of the Chinese tutoring industry in July. While many had expected much stricter regulation of tutoring at weekends and holidays, few had anticipated what amounted to a very controlled ban through the introduction of a not-for-profit model. This black swan event spread panic across the internet, healthcare and consumer discretionary sectors as investors feared they could be the next target of regulatory clampdowns.
In August, further light was shed on Chinese policy direction with President Xi’s emphasis on “wealth redistribution for common prosperity”, driving a rotation from policy headwind sectors such as internet, luxury and real estate towards tailwind sectors like the electric vehicle value chain, semiconductor technology and high-end manufacturing. To compound equity market pressures, September saw the emphasis move to the USD 60 trillion Chinese property market as Evergrande’s potential debt default raised concerns on systemic risk (even quoted by some in the media as a ‘Lehman moment’). Just when things looked like they could not get any worse, the end of the quarter saw large scale power outages occurring in more than half of the Chinese provinces, further dampening the GDP growth outlook for Q4.
It is worth remembering that many of the policies (anti-monopoly, real estate, three redlines, etc) had already been proposed in Q4 2020, but the duration, intensity, scope and velocity combined are unprecedented in recent history. The unpredictable nature of regulation has spooked many global investors as funds moved underweight China in the third quarter, with Chinese equities underperforming their counterparts in the US by circa 30% despite a higher growth rate.
The conundrum – grow the pie or split it?
From a Chinese internal standpoint, 12.7% growth for H1 2021 leaves plenty of scope for a sharply slower second half when considered against an annual target of 6%. The more pressing task for the regulator, in our view, will be the management of 2022 and the requirement to keep growth going.
China’s large population, which once fuelled the fastest growing major economy globally, is now slowing and ageing. While annual population growth slowed to 0.5%, the 2020 census suggests the elderly dependency ratio has doubled over the past 10 years, adding a burden to China’s already in-deficit pension system. The regulator reacted swiftly by abolishing its decade-long one-child policy, only to find out a second / third / unlimited child policy is not enough to incentivise more births.
Consequently, a second solution was introduced consisting of actions to clear all obstacles that could be seen to hinder births. In particular, three sectors were targeted – education, housing and healthcare – as they are deemed to be the heaviest burden for household income and wellbeing. The front runner was the crackdown on the private tutoring industry with a K12 (kindergarten to 12th grade) student in China taking as much as half of the disposable income of a less-well-off family. Paired with this is the desire to curb ever-escalating house prices, given property locks up over 60% of household wealth in China. The cooldown in sales of property, paired with a rigid restriction on developer leverage, had also foreshadowed the Evergrande episode into September. Last, authorities have levelled up national drug procurement to include medical equipment. This, combined with a pricing reform on healthcare services, shocked the private hospital industry.
Facing a population conundrum and a growth bottleneck, authorities have inevitably refocused from growing the pie to splitting it. An economic slowdown will hurt the underprivileged more than the affluent, while the key to social stability depends on the least well-off under the pyramid. Hence the ideology of ‘common prosperity’ from Das Kapital, once targeted to be achieved by 2050, has been brought forward to address the rising demand of the social safety net. Such a statement has been interpreted as far left given global investors focused more on ‘common’ over ‘prosperity’. Corporates also speedily reacted as large-cap internet platforms like Tencent, Meituan and PDD all advocated such a cause by setting up billion-dollar common prosperity funds or realigning their corporate strategy to enhance social responsibility.
Looking beyond the turbulence
Such drastic measures have not only damaged stock market sentiment, but also impaired businesses and livelihoods. Hundreds of thousands of jobs vanished overnight from the tutoring industry, lifetime savings locked up in housing depreciated and medical resources became scarce as the low-price procurement exacerbated a shortage. The rigorous attitude from the central government has also resulted in reckless local policy execution. Recent power outages that aimed to curb energy-intensive manufacturing spread to consumer power usage. Macro numbers have also been unfavourable with August retail sales growth falling to a one-year low of 2.5%, and September’s manufacturing PMI contracting for the first time since the Covid-19 outbreak.
Onshore China is eagerly awaiting a liquidity injection to support the slowing economy. Although it is still too early to wish for a reversal of the clampdown, regulators have been placing a safety net to secure economic activities. As Q4 has traditionally been a peak season for manufacturing and consumption, running such favourable seasonality into a macro-heavy calendar might be too costly for the regulators, especially ahead of an important political period in Q1 2022.
We believe investing in this environment requires a change of focus. We are looking towards the policy-tailwind sectors that the authorities see as long-term leaders. The key word for the Chinese political agenda has become “restructuring”; reducing reliance on labour and imported technologies, and overtaking incumbents in a Digital 4.0 world. China had a head start in decarbonisation technologies. We think green development and decarbonisation will be a major beneficiary of a changing political agenda and have been investing into the policy tailwind with positions in the electric vehicle value chain and corporate digitalisation.
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