China equities manager May Ling Wee highlights the key opportunities and risks facing the asset class in 2021.
- Chinese stocks’ strong performance in 2020 resulted from the government’s firm COVID response that ensured that China was ‘first out’ of the pandemic.
- China looks poised to benefit from a global recovery as vaccines are rolled out; financial services, select internet companies and consumer cyclicals are presenting attractive opportunities.
- Key risks include tightening government policy, the ongoing strategic rivalry between China and the US, as well as state intervention in antitrust and the regulation of internet companies.
2020 confirmed again that investing in China is driven by a confluence of macroeconomic and microeconomic factors, and that government policy and willingness to support the economy is a large determinant of market sentiment. The government’s response to COVID, which started with lockdowns of entire provinces followed by credit and fiscal easing ensured that China was ‘first out’ of the pandemic. This led to strong market performance in 2020 despite a year that saw corporate earnings downgrades and a very difficult second quarter. Domestic and offshore Chinese equities listed in Hong Kong and the US finished the year up 28.3% (MSCI China Index), while domestic stocks only, ie, those listed in the Shanghai and Shenzhen markets, delivered gains of 29.9% (CSI 300 Index) in yuan total return terms.1
Amid this strength, we see several scenarios that present some attractive opportunities for investors in Chinese stocks this year, but there are also several key risks that warrant careful consideration.
Global and domestic recovery on a successful vaccine rollout
A successful rollout of the COVID vaccine will lead to improved business confidence globally, and is likely to create a favourable backdrop for China’s industrial and export-oriented sectors. China’s share of global exports has risen amid the global downturn, with most of the global supply chain disrupted. Additionally, cyclical consumer companies also look to benefit. As consumers turned cautious on spending due to COVID, saving levels were boosted. This provides more spending power and we expect consumption to rise with improving consumer confidence.
Financial services still very much a long-term growth sector
The life insurance sector suffered last year because life policies tend to be sold rather than bought in China. A lack of face-to-face interaction caused by COVID made sales of life policies more difficult to new clients. Coupled with a resumption in new business growth after a very difficult 2020, the potential for rising dividends and still attractive valuations are factors that could possibly create a more favourable backdrop for the life sector.
We think the wider financial services sector has significant growth potential. The post-World War II baby boomers is a large cohort that is reaching retirement age this decade. The collective wealth of China’s ageing population creates many opportunities in sectors such as life and health insurance, as well as wealth management, given this generation of retirees are wealthier, more willing to spend and invest in comparison with the last.
Valuations of the largest internet companies still appear reasonable
In our view, China’s leading internet platforms still trade at attractive valuations relative to their potential growth and ability to compound earnings and cashflow over time. These businesses have proved that their focus is on continuing to innovate, evolve, create and strengthen existing and new business lines, which has ultimately led to sustainable growth.
However, government policy is expected to tighten
China’s economy has surpassed its pre-COVID levels and its domestic economy is experiencing more balanced growth, with improvements in sectors such as consumption and private manufacturing investments. As a result, the government is likely to tighten monetary and fiscal policies; indeed, we have already seen new total social financing2 (the aggregate volume of funds provided by China’s domestic financial system to the private sector) starting to turn. In the past, this has tended to have negative implications for the performance and valuations of Chinese asset markets. 2020 saw multiple upward revaluations of stocks and as we write, many leading domestic stocks are currently trading above their average historical valuations.
Geopolitical risks are embedded in the investment landscape
Despite a new US administration, it is possible that China-US relations see little improvement. Geopolitical risks, even if less confrontational than before, are unlikely to go away as the strategic rivalry between China and the US remains. In the final weeks of the Trump administration, an executive order has banned US investments in Chinese companies linked to the Chinese military, with three Chinese telecom giants set to be delisted from the US stock exchange. The US Entity List is unlikely to be removed, meaning Chinese supply chains remain at risk and companies continue to face the possibility of being delisted from US stock exchanges. There are many levers for the US to pull; not just in terms of trade and tariffs, but also sanctions on financial institutions and preventing Chinese corporates from accessing US technologies and financing.
On a more positive note, while US stock exchanges become less viable listing locations, Chinese companies may increasingly be turning to Hong Kong, Shanghai and Shenzhen markets to fund their growth, particularly as China further develops and opens its capital markets.
The role of the state is all encompassing
The current focus on ensuring that online businesses compete on fair grounds and are subject to the same regulatory requirements as their offline peers, can impact and change business models and growth trajectories, such as in the case of the largest internet and financial tech companies. Antitrust and fair competition proposals as well as fintech regulations create an overhang on online businesses, which today form a large section of the offshore China market.
Despite a very challenging economic backdrop, China’s leading companies proved very adaptable in facing the pandemic, innovating ways to bring goods to their consumers and ensuring that supply chains were functioning. This led to strong performance for those companies that adapted fast and many have prospered despite COVID. We maintain the view that the Chinese consumer is the foundation of the investment case in China, and are now seeing a pick up in consumption, now that consumer confidence is rising. For these reasons, we expect global allocations to Chinese assets should increase if China’s economy continues on its long-term growth path.
1Source: Refinitiv Datastream. Index total returns for the 12 months to 31 December 2020. Past performance is not a guide to future performance.
2Total social financing or TSF is a broad measure of credit and liquidity. It includes off-balance-sheet forms of financing that exist outside the conventional bank lending system, such as initial public offerings, loans from trust companies and bond sales.
US Entity List: a US Department of Commerce published list of foreign individuals, businesses and organisations that are subject to specific license requirements for the export, re-export and/or transfer (in-country) of specified items.
Monetary policy: actions of a central bank aimed at influencing the level of inflation and growth in an economy. Monetary tightening refers to reducing the supply of money and raising borrowing costs.
Fiscal policy: steps taken by a government to influence economic conditions through government spending and/or taxes. Tightening/contractionary fiscal policy involves reducing government spending and/or raising taxes.
Cyclical companies/stocks: these companies and their share prices tend to be more affected by the ups and downs in the overall economy. Examples include discretionary consumer products and services such as cars, entertainment and retail.
The MSCI China Index captures large and mid-cap Chinese stocks listed both in the domestic China markets and offshore listings in Hong Kong and the US.
The CSI 300 Index tracks 300 stocks with the largest market capitalisation and liquidity from the entire universe of listed A share companies in the People’s Republic of China.