Navigating China’s cycles through a long/short lens
UBS O’Connor seeking potential alpha opportunities in China
Investors have often seen China as a one-way bet on growth. That is perhaps unsurprising: since Deng Xiaoping began his far-reaching economic reforms in the late 1970s, the country has averaged annual GDP growth of 9%1. But having emerged from COVID lockdown, China has struggled to get its economy back on track.
This year, the government is targeting GDP growth of just 5% – a far cry from the heady heights of the preceding decades. The slowdown in the economy has led to huge fund outflows this year, with geopolitical tensions and a debt-stricken property sector adding to the malaise. Chinese stock markets have fallen to their lowest levels since before the COVID pandemic.2
But we think that investors’ macroeconomic focus is misplaced. The macroeconomic cycle is just one of four key cycles in China, each of which offers structural alpha opportunities both long and short. A long/short approach potentially captures a differentiated source of returns and complements a beta-driven strategy while improving risk-adjusted returns across different market cycles.
The economic cycle – lower growth for longer?
The economic cycle – lower growth for longer?
- China’s GDP growth target is a modest 5%, signaling a departure from historical highs.
- Demographic shifts, falling return on invested capital (ROIC) and artificial intelligence (AI) development challenges contribute to the evolving economic landscape.
China’s organic GDP growth appears to be heading toward a naturally lower level. The country’s ageing population and falling birth rate mean that it is subject to considerable demographic shifts, with knock-on consequences for growth. Although the one-child policy has been abolished, single-child families are now a long-established norm.
Meanwhile, the return on invested capital (ROIC) is falling. This is because China’s markets now offer fewer assets that can generate the eye-catching yields once available from property developers and local-government financing vehicles. Also, many Chinese firms are investing heavily in research & development, constraining ROIC in the near term.
And in the age of artificial intelligence (AI), there are also pressures on development from bottlenecks in the semiconductor industry as China struggles to produce the chips required to harness the computational power of generative AI.
The political cycle – a change in emphasis
The political cycle – a change in emphasis
- Recent market volatility stems from government priorities shifting toward de-risking and social stability.
- Structural reforms aimed at achieving “common prosperity” indicate short-term market volatility.
One explanation for the recent volatility in Chinese markets is the difference in perspectives between the government and investors. Since the pandemic, de-risking and social stability have clearly taken priority over economic efficiency.
Given this, we should expect more volatility in the short term as Chinese policymakers implement structural reforms to expand the drivers of the economy and pursue the goal of “common prosperity” and a more equal society.
The inventory cycle – the beginning of the end?
The inventory cycle – the beginning of the end?
- China approaches the trough of its destocking cycle, suggesting a boost in the job market and consumer activity.
- Opportunities may arise along the supply chain as companies adjust their inventories.
China’s inventories are an important indicator of nascent economic trends. It’s always hard to call the turn precisely, but in our view the country now appears to be approaching the trough of its current destocking cycle.
When companies start to build up their inventories once more, the job market, the consumer, and the overall economy should all receive a boost. In the meantime, the inventories of individual companies can help to point investors towards long and short opportunities along the supply chain.
The technology cycle – beware the bubble!
The technology cycle – beware the bubble!
- Hurdles like limited computational power and geopolitical risks challenge China’s technological advances.
- Alpha opportunities lie in discerning between companies with transformative potential and those facing valuation corrections.
At present, China faces several hurdles in its attempts to make technological advances. Obstacles include limited access to advanced computational power, geopolitical risks and the trade sanctions imposed by the US. These could cloud the outlook for commercialization by domestic technology companies for some time.
Earlier this year, generative AI prompted frenzied buying in the Chinese markets. Here, we should be aware of a familiar pattern when new technologies emerge. Recent examples include 5G, virtual reality, and antimicrobial fabrics. In each case, the initial frenzy gave way to a correction once the excitement abated.
Where we see alpha opportunities
Where we see alpha opportunities
Many investors appear confused and have struggled to invest in China successfully as some of the well-known investment principles to trade the China market seemed to have broken down; hence four consecutive down years in equity market performance. In our view, this actually implies a new playbook and investment paradigm are needed.
The same tech cycle looks set to play out in generative AI. Although it is still in its nascent stages, we are confident that AI will transform the Chinese economy by improving productivity. So it is in the government’s interest to remove impediments to its adoption.
We believe that some Chinese companies that are producing large language models (LLMs) are likely to proceed rapidly to commercialization. However, LLMs facing challenges in usability and cost-effectiveness may present shorting opportunities. Following this year’s surge in AI-related stocks, signs of potentially inflated valuations are emerging. This may create attractive entry points in companies with genuine transformative potential, requiring careful stock selection.
Meanwhile we think that the troubled property sector offers shorting opportunities in privately owned developers, which may not benefit from the support that their state-owned peers are now receiving from the authorities. More broadly, reforms at state-owned enterprises are allowing them to return more capital to investors – making them attractive long-book investments in China’s low-interest-rate environment.
Chinese markets shifted in August 2023, prompted by real estate and healthcare challenges. Our strategy showed resilience with strong alpha, thanks to a defensive portfolio and strategic short exposures. Policymakers responded with accelerated supportive measures, leading to a more constructive outlook, especially in the real estate sector. Positive signals from the private sector and expected recoveries in financing and prices contribute to a cautiously optimistic view.
As the costs of raw materials rise, leading to margin squeezes in traditional Chinese medicine companies, our focus on the healthcare sector gains significance. Amid China’s pharmaceutical industry’s low single digit growth, its resilience during the pandemic, robust balance sheets, and financial activities suggest a favorable environment. The biotech industry’s first mover advantage, especially in Contract Development Manufacture Organization (CDMO) and Clinical Research Organization (CRO) businesses, is strengthening. We acknowledge potential challenges with the rate hike-cycle and emphasize selective investment, focusing on R&D quality and cash burning rates in biotech. Exciting opportunities may arise in therapeutic drug development, addressing gaps in hypercholesterolemia and HBV treatments. In our view, China’s efforts to strengthen intellectual property rights, evident in increased Patent Cooperation Treaty (PCT) submissions, position it as an efficient and competitive market, which we see creating alpha opportunities through our relative value approach.
The long and short of it
The long and short of it
Navigating China’s cycles demands a discerning eye. Alpha opportunities may emerge in the troubled property sector, state-owned enterprises, and industries grappling with rising raw material costs. We believe that strategic stock-picking is vital, offering investors a pathway through the complexities of China’s evolving economic landscape.
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