A new game plan to invest in China

Highlights from the China Forum 2023 on 19 October 2023

China Fixed income Active equities 25 Oct 2023

Authors

Raymond Yin Hayden Briscoe Bin Shi Raymond Gui Jade Fu

Negative headlines and market volatility have plagued China this year. Many international investors have headed for the exit, dismissing China as no longer investable. But we disagree.

The old growth model for China, powered by low end manufacturing, infrastructure spending and property market, is firmly in the past. The new China will focus on technology, high-end manufacturing, value-added services and consumer spending. In doing so, it will follow a well-trodden path of transitioning to a middle-income economy, but with the additional challenge of achieving this as the world’s second biggest economy. While the transition has presented considerable challenges, supportive policy measures and nascent improvement in economic indicators in recent months tell us that China is heading in the right direction.

As China evolves, the overall investment case holds true for us. However, we believe a new game plan is required to identify the potential catalysts capable of fueling a broad-based market recovery as well as the new opportunities on the horizon.

Catalysts for the economy

A firm and stable direction in government policy could set clear expectations and reduce uncertainties, and we are already seeing a policy turn. This started with the lifting of certain controls on house purchases across Chinese cities. A stronger division between markets and government could also make the business environment more predictable.

Given the economy’s current malaise is largely the result of a significant drop in confidence, a massive stimulus package – something we do not see happening anyway – is beside the point. Cyclical factors are not the main reason for weakness in the post COVID recovery.

Spending power is there, as evidenced by high savings deposits, but households and businesses have been conservative and held back from investing for the long term. Fortunately, that appears to be changing.

Early signals of stabilization in consumption, business sentiment and credit impulse are encouraging, as are improving data in the manufacturing PMI and aggregate financing. We expect the economy will continue to look up, but it takes time for sentiment to recover and for new policy measures to have an impact.

The PBOC has room to ease monetary policy, through lowering the bank reserves and lending rates to support the budding recovery. Replacing large scale stimulus with specific rate adjustments, the V shaped economic cycles could become a thing of the past.

While economic cycles will likely become longer, we also expect an overall slower growth environment for China, which should come as no surprise to investors. However, there can still be plenty of investment opportunities in a slower growth environment: the US is an obvious example.

We need to be realistic and practical, but we anticipate sustainable growth will once again be established. We remain disciplined in our investing philosophy, but are also making changes and thoughtfully adapting to a shifting market environment.

Here are some of the reasons to keep investing in various asset classes in China.

China equities: Investing in industry leaders to deliver alpha

Many Chinese companies are going global and successfully competing with well-established global brands in international markets. Not only are they adapting to the various external challenges in this volatile environment, they continue to invest in technology, invest in research and development (R&D), control costs and grow their business. We are focused on companies with strong fundamentals that are growing their market shares in and out of China despite the challenging market environment.
Consumption is gradually improving, supported by hints of early recovery in retail sales and income growth. We continue to look for opportunities that could benefit from such progress, i.e. select game developers, electric vehicle manufacturers, ecommerce companies and machinery makers. On the whole, our investments are now more concentrated in high quality companies than before.
Low valuations of Chinese equities have already accounted for market pessimism, with H shares being more depressed than A shares. However, as global investors pull funds out of the region, domestic institutions are increasing their H share allocation, which makes a stronger rebound possible when market mood does turn. We believe the asset class still holds significant opportunities for active investing.

Changes and opportunities in China fixed income

China’s recent key economic data such as the manufacturing PMI have shown early signs of stabilization. We are awaiting the potential boost from recent policy support on residential property sales.
China’s offshore USD credit market has undergone both a structural shift with the real estate sector becoming much smaller than before and an increase in diversification across sectors and industries.
Real estate now makes up a smaller proportion of the China credit market as well as of Asia high yield. Any additional negative impact from the sector should therefore have less of an impact on fixed income markets in China and the region.
China’s onshore RMB bond market has outperformed since 2021 due to the different interest rate cycles between China and the US. It offers diversification benefits to a global fixed income portfolio because of its low correlation with other developed bond markets. In addition, the asset class provides a positive real yield when comparing the 10-year government bond yield to core inflation.
Local government funding vehicle debt is a sizable portion of China’s domestic credit market. Recently, the regulator has offered a round of debt swaps, which allows local governments to issue new bonds and swap out risky debt. The program has had strong uptake since September 2023, meaningfully lowering tail risk in the sector.

The multi-asset angle is beyond equities and bonds

Multi-asset investors invest in a range of diversified asset classes with the goal of providing a smoother investment journey. An active multi-asset approach to China could enable investors to stay in the market through the ups and downs of an economic cycle with much lower volatility.
China is one of the few markets where the traditionally negative stock/bond correlation still holds. The country’s muted inflation, especially when compared to developed markets, is a major factor.
Beyond allocating across equities and bonds, a multi-asset approach can be granular and examine opportunities in sub-asset classes. We also try to capture alpha on thematic opportunities as they continue to evolve.
We like China state owned enterprises(SOEs)and their defensive quality in the current volatile environment. They have performed better than the broader market, and are in sectors that are strategically aligned with government policy.
AI is also an important theme with a huge wave of opportunities. From a top down perspective, we try to participate when the growth prospects and valuations are right.
More broadly, flows from the US and European are supporting Indian and Japanese markets. Investors appear to be concerned with the trajectory of the China markets, yet want to stay invested in the region.