The China alpha story

Investors have become growingly hesitant of their allocation to China given this year’s intense market volatility and velocity. Because of the country’s decade long, strong secular growth, a long-bias investment approach is often the default when it comes to China. However, in recent years, this approach has proven challenging in generating competitive risk-adjusted returns. On the back of the uncertain short-term outlook and evolution of the Chinese capital market, we believe this is the right time to think about alpha opportunities—not just beta—and consider a relative value approach to investing.

To talk about the reasons for using a hedge fund strategy to capture that alpha, we first have to talk about the slowing Chinese economy and policy changes.

We see the regulatory reforms in the past 12 to 18 months as a rebalancing of resources between capital and labor. The ongoing challenge for policymakers both in China and globally is to decide between efficiency and equality. Reforms based on the common prosperity theme are intended to prevent monopolies, which create a level playing field not just for companies but also across sectors, to achieve better equality for the people.

As policymakers pivot away from peak regulations and focus on hard technology development and innovative business models, we see many thematic opportunities, especially in advanced manufacturing industries including electric vehicles, solar power, robotics, automation and semiconductors. Carbon neutrality could also provide an exciting opportunity in this decade. As consumer preferences diversify, we believe that brands that can meet the varying needs of the Z-generation, growing middle class and aging population may have a big win.

For the beleaguered property market, we expect volatility to remain in the short term. Worries of the sector’s downstream impact on local government financing vehicles, discretionary consumption and banks’ asset quality will probably linger in the next few months. Longer term, we see accelerating market consolidation as beneficial for the health of the sector. Property demand is driven by urbanization—and well supported by the growing wealth of the middle class, young graduates and newly married couples. In our view, this should create a floor to the correction we are experiencing. Ultimately, we believe the Chinese economy will become less sensitive to real estate investment and property bubbles as land prices come down and local governments shift their attention to manufacturing sectors.

Understanding the policymaking process as things evolve is the key to making the right investment calls. With the recent session of the National Party Congress, our focus is on understanding the long-term and short-term priorities for the new government. That is why we place strong emphasis on building a local presence and counting on that well established network and deep relationships with companies. We believe that adding on-the-ground knowledge to our investment process helps us stay close to changes coming from the government and better prepare for the impact. It also allows us to be more independent and critical in our thinking, making room for informed, objective contrarian calls should they be supported by strong catalysts. We believe that this has helped us minimize downside risks as well as avoid being caught in a herd mentality.

But back to the recent market volatility, we think that economic growth will remain the long-term priority for the Chinese government, and its policies will be aligned to achieve that. That pro-growth commitment has not changed since 1979 when reforms were first introduced to bring China into the global economy, and we don’t feel that it is something the current leadership would take lightly. All in all, our long-term outlook on China investing is positive.

Outside of China, the developed market is struggling with rapid inflation. High inflation readings in the West can be traced back to many different factors, but central banks’ response to the pandemic is a major one. If we look at the US, the Federal Reserve cut and kept interest rates at historical low levels while the US government provided additional stimulus, misjudging the strength of subsequent rebounds—and how high prices would rise. China’s monetary policy response to COVID was quite different, and it is currently the only major economy with an easing bias, having cut interest rates and bank reserve requirements recently.

And also, at a granular level, the composition of consumer price index (CPI) baskets is quite different for the two countries. The US CPI basket has a higher weight in transportation and shelter, whereas China’s has a higher weight in food and clothing. Transportation costs were driven significantly higher by soaring energy prices triggered by the war in Ukraine. A possible consequence from the US and Europe’s inflation stress and slowing global economic growth would be lower demand for Chinese exports. This headwind together with China’s zero COVID policy and weakness in the property sector are the primary reasons for a defensive position this year.

To begin with, we feel that there are inefficiencies in the onshore China A-share market that a hedge fund strategy can exploit. Such inefficiencies come from high retail participation, low sell-side research coverage, low institutional penetration and high turnover. Adding to that, a relative value, long/short approach may help minimize downside risk—much needed in the current volatile market environment—while allowing investors to maintain exposure to the long-term China growth opportunity. The nimbleness of a long/short strategy may protect capital during periods of short-term volatility and may be in a position to capture the upside ahead of the rebound.

At the core we focus on fundamental, deep primary research and our team of analysts work hard to identify idiosyncratic opportunities on both the long and short sides of the portfolio. We closely follow macroeconomic and government policies seeking to better navigate major inflection points and identify thematic opportunities. We understand there is a lot of reluctance with investing in China right now, but don’t overlook the China alpha story.