Investing in an evolving China with an All-China approach
In our view, investing in an evolving China can be both challenging and rewarding. Global investors experienced volatility and rapid changes in the regulatory environment for China equity in 2021. Some may ask: is the risk-reward profile for China equity still appealing enough to justify meaningful exposure in a diversified global equity portfolio? And how should investors navigate the changing dynamics of China equity for those who wish to participate in the country’s long-term growth prospects?
To put things into perspective, China equities are typically defined as either onshore or offshore. The former covers mainland China listed A-shares, while the latter encompasses Hong Kong or US-listed China companies, with different sector exposures. We explore why investors should consider adding China equities to their portfolios via an All-China approach. And for those who wish to participate in the long-term growth of China through China equity, how to navigate the changing dynamics in the world’s second largest equity market.
Section 1: China still offers global investors an attractive proposition, and we advocate an All-China approach.
A. Where does China stand today?
For investors, China is simply too big to ignore. It is the second largest economy in the world1 and one of the key growth engines globally. China represented roughly one-fifth of global economic output in 2020 (see Chart 1) and accounted for around 16% of the world’s total market capitalisation (inclusive of Hong Kong), making it the world's second-largest contributor (see Chart 2) after the United States. Meanwhile, China’s weight in the MSCI All Country World Index is only 3.6%2. As a result, China’s economy and growth contribution to the world is underrepresented by most international market-capitalisation weighted indices.
Chart 1: China is under-owned compared to its global size and influence
Source: IMF, World Bank, the World Factbook, March 2021.
Chart 2: World stock exchanges by market capitalisation (US$ trillion)
Source: Bloomberg, as of 26 January 2022.
B. Policy goals: transitory impact for the long-term good
The changes in China’s regulatory environment since late 2020 have surprised many global investors. From launching antitrust investigations into e-commerce platforms and placing restrictions on youth playing video games to banning afterschool tutoring for profit, the rapidly shifting landscape of reforms in social and regulatory matters has introduced uncertainties into China equity's risk-reward profile.
It is important for investors to remember that this is not the first time the Chinese government has engaged in a regulatory shake-up of economically important industries. Recent efforts include supply-side reforms and price cuts for generic pharmaceuticals from centralised bulk purchase orders. It will probably come as no surprise if more such measures follow.
While reforms can create short-term volatility and uncertainty for equities, their goal is to create better-functioning markets for the long-term benefit of society. The strict measures and regulatory clampdown via anti-trust legislation have led to operational changes by internet blue-chip giants. This could foster a more open and competitive business environment for the internet sector as a whole, and create opportunities for smaller niche players.
Indeed, these regulatory reforms are part of a larger policy push for “common prosperity”, an idea espoused by President Xi Jinping in 2021. The pursuit of common prosperity may raise questions among global investors as to how companies, corporates, and the investor community will benefit from this policy.
We believe that common prosperity aims to reduce the differences between individuals, regions, and urban/rural areas to acceptable levels; corporate profitability and capital accumulation would remain. Increasing the overall pie is the foundation of common prosperity. Indeed, a key goal of common prosperity is to further rebalance the domestic economy towards consumption and away from a reliance on exports, while lowering the import/export share of GDP to 25% from 35%3. Longer term, it seems clear that government policy will aim to reduce the real estate sector's contribution to economic growth; the sector is currently the single largest in China’s GDP composition4. Another key goal from China’s common prosperity pledge is to increase GDP per capita from $10,000 in 2020 to $23,000 by 20355. Sustainability-driven capex investments and domestic consumption growth are therefore to be promoted, supported, and prioritised.
To achieve this, we believe that the Chinese government will need to foster the development of other industries such as biotech and industrial automation. This is even more important due to the chronic friction in the Sino-US diplomatic relationship. From this perspective, we see compelling structural opportunities across many sectors that can ride on key secular trends, such as domestic consumption and localisation of the semiconductor supply chain, advanced manufacturing, and the push for electric vehicles (more in Section 2).
"As a fundamental bottom-up driven investment manager, we use our analytical lens to look through short-term volatility and noise, and ensure that our investment theses are robust enough to capture mispricing opportunities in different market conditions."
C. Benefits of the All-China approach
For investors interested in the opportunities offered by China equities, there are a variety of different ways to gain exposure. We advocate an All-China approach to the asset class. Indeed, while some funds offer products that access mainland China or Hong Kong equity markets separately, we believe that a hybrid approach offers greater flexibility and opportunity for investors. Thus, based on our conviction, we invest in equities listed in mainland China and Hong Kong, and in depository receipts listed in overseas markets, including the United States. (See the Appendix for a brief description of the different ways investors can invest in All-China equities.)
In our view, China equities offer an exciting and rapidly expanding investment universe. The total number of onshore and offshore listed Chinese companies, with a market capitalisation exceeding US$500 million, had grown significantly to over 4,325 as of the end of 20216, an increase of nearly 57% from 2018. This was driven by a buoyant IPO market, which recorded a healthy number of China listings on key stock exchanges. The large number of listings, coupled with an ever-expanding investor base, gives rise to opportunities from potential mispricing.
For global investors, the All-China approach has led to attractive returns (See Chart 3). In addition, with financial markets more volatile, the All-China approach to investing in China equities allows investors to benefit from a variety of sectoral and market-capitalisation opportunities (Chart 4). This is particularly so if investors include Hong Kong equities as part of their overall exposure to enhance stock selection opportunities for companies deriving growth from China but with different macro and micro drivers. Hong Kong looks set to continue benefitting from various IPO pipelines and from being a capital raising hub for institutions such as international banks and insurance giants.
Chart 3: Attractive returns from navigating both onshore and offshore China equities
Chart 4: Broader sectoral opportunities and market-cap opportunities
Opportunities set by sector % of index weight
Source: MSCI, S&P, Bloomberg, as of 30 September 2021.
Opportunities set by market capitalisation, by number of stocks
Source: Bloomberg, Shanghai Stock Exchange, Shenzhen Stock Exchange, as of 31 March 2021.
Opportunity for alpha and diversification
Empirically, alpha opportunities are evident in China equities. Nevertheless, the ability to capture them requires on-the-ground resources and informed perspectives. This is especially so in a complex and fast-developing market like China, where informational advantages and mispricing opportunities arise from the dislocation from fundamentals. Therefore, we believe that on-the-ground research, stringent stock selection, and active management are critical to capturing alpha.
While not all stocks are winners, China equities could offer ample alpha opportunities. Chart 5 shows the five-year excess return dispersion of key equity markets. As can be seen, China equities generally offer a wider dispersion of returns compared with their developed and developing market peers. This means that historically, the range of potential returns for this asset class is wider, allowing discerning stock pickers to capture higher upside potential.
Chart 5: China equities have generally offered a wide dispersion of returns over the past five years
Wide return dispersion for China equity, even within sector
Total cumulative return dispersion per sector over past 5 years (%, p.a.)
China equity presents more alpha opportunities
Five-year excess return (p.a. %) over manager benchmark
Foreign investors in China equities may benefit from portfolio diversification. From a tactical perspective, China has been decoupling from developed markets and other emerging economies alike. The low correlations stem from the fact that government policy in the country has been significantly different from other markets, rather than stemming purely from flows and liquidity. China’s decoupling from the US and countercyclical fiscal and monetary policies can provide attractive alternatives to global investors who would like to diversify from the Fed’s policy moves. Over the past ten years (see Chart 6), investors in China equity have benefitted from lower correlations of their investments to both developed global and emerging markets.
Chart 6: From a longer-term perspective, foreign investors have benefitted from lower correlations in China equities over the past 10 years
Section 2 – What to expect from China’s growth story and China equity? We take a look at the opportunities in key sectors.
A. Growth still solid and diversified across industries
Despite a volatile 2021, we believe that China’s growth story is still vibrant. Indeed, while government regulations may continue to change in key sectors, investors should look to broader, longer-term opportunities in essential areas such as domestic consumption/innovation and sustainability-related themes, including carbon neutrality and changing demographics.
Electric-vehicle batteries: Innovation on the global stage
We believe that domestic drivers such as consumption and investment will be the key catalysts for economic growth and equities, with innovation in the digital economy and biotech as the anchors. Furthermore, as China aims to strengthen its position as a high-value global manufacturing hub, industrial automation and manufacturing upgrades led by advanced technology will also be in focus as the country faces future demographic and productivity challenges.
After all, digitalisation and consumption growth are critical for China to progress. In the Politburo's October 2021 study session, the central government called for co-existence of regulation and development for internet platforms and stated that the digital economy is crucial for enhancing productivity and international competitiveness. In January 2022, the Chinese government also published a plan for the development of the digital economy as part of its 14th five-year plan, aiming to boost the sector’s share in the national GDP to 10% in 2025 from 7.8% in 2020.
We believe that electric-vehicle battery manufacturers are a key part of the innovation agenda. As shown in Chart 7, Chinese manufacturers already account for over half of production in global markets.
Chart 7: Importance of China’s battery supply chain in global market (2021 market share)
Source: "China Battery Supply Chain" research report from Morgan Stanley, as of 3 January 2022. PVDF stands for Polyvinylidene Fluoride and is a component commonly used in lithium-ion batteries.
Renewable energy: The peak of carbon emissions and the pursuit of net-zero
In October 2021, the State Council proposed the Action Plan for Carbon Dioxide Peaking before 2030. Under the plan, by 2030, the share of non-fossil energy consumption should reach around 25%, and carbon dioxide emissions per unit of GDP should drop by more than 65% (compared with the 2005 level), successfully achieving a peak of carbon dioxide emissions before 2030.
We see solid growth drivers in the renewable-energy sector, which is a strategic priority for policy-directed funding. The construction of wind and photovoltaic bases has already been accelerated thanks to the elevated pace of government bond issuance and policy support. Over the longer term, we expect a roadmap that will help China’s journey towards peak carbon emissions by 2030, placing the country’s decarbonisation efforts under a more structured framework. Overall, we believe that if China can convert this energy problem into a manufacturing one, this would help the country greatly in achieving peak carbon emissions, and ultimately carbon neutrality.
Cosmetics: Opportunities in shifting demographics
Changing demographics are reshaping the investment landscape and available opportunities in China. Importantly, this change is in tune with local tastes. We already see this in the evolution of products and brands aimed at old and young alike. The consumption upgrade for China’s population, especially the middle class, is demonstrated by the shift in demand from goods to high-quality lifestyle services like property management and ‘experiences’ such as travel. For consumer products, the commercial winners will likely be determined by those that can adapt quickly to local tastes. We have seen Chinese brands gain market share from foreign equivalents in multiple categories such as sportswear, skincare, and cosmetics.
Chart 8: Chinese brands’ share in domestic cosmetic sales (makeup, %)
"The beauty of China equity is its breadth and depth, which allow us to dig deep even in niche growth areas. Greater Bay Area is an interesting example, where we see plenty opportunities for regional champions to flourish."
B. Capital market development and China equity listing
As China’s contribution to the global economy grows, institutional investors should consider participating in this growth via equity exposure, in our view. This would likely mean carving out a dedicated allocation to China, as the country is under-represented in industry benchmarks. As mentioned in Section 1, despite the country’s significant size and influence, China equities are still arguably under-owned by investors; their weighting in the MSCI All Country World Index is currently only 3.6%7.
The integration of China equities into the world financial system, through their addition to global indices, has raised the profile of many Chinese companies. The rise of corporate juggernauts in wide-ranging industries, from technology to manufacturing, has also caught the eye of global investors.
Under the common prosperity ideology, we believe that smaller companies will benefit directly from more balanced growt