Investing in China with patience and confidence

Barry Gill: What do you think will be the dominant investment themes in China in the coming 12 months?

Dr. WANG Qing: It is hard to identify an investment theme that could last for 12 months in a very bearish market environment. Despite that, we are actually quite constructive on the Chinese market for three reasons. First, tail risks for a major growth plunge have been greatly reduced since policies have become reflationary. Second, much of the deteriorating fundamentals that drove last year’s market downturn are now priced in. Third, should the US cut interest rates as forecasted, the headwinds from tight global liquidity conditions for A and H shares could turn into tailwinds. Taken together, we see limited downside risks at current levels.

We are alpha-minded rather than beta-minded at this juncture. The beta environment is less than exciting to us with the visibility of a strong and broad earnings upturn still low, whereas there are plenty of alpha generation opportunities. In particular, medical innovators in pharmaceuticals and devices that are competitive globally show promise. We also like tech-savvy advanced manufacturers that align with policy priorities and hold bottom-up cost advantages over their competitors. And we like a few high quality dividend stocks as a hedge for potential downside risks.

Dr. SANG Jun: We are constructive as well and are focused on A share companies that are entering and competing in overseas markets. International markets are where growth is, and being globally competitive and exporting overseas are the most telling sign for the growth potential of a Chinese company – not just for the next 12 months but for the years ahead. If you look back to the 1980s and 1990s, Japanese companies that were able to establish an international foothold are the ones that are still standing today.

In many ways Chinese companies are well positioned to go global. The COVID pandemic has made online international shopping easier and more popular, and Chinese companies should take advantage of this changed environment and better access than ever to overseas consumers. With most in the early stage now, we are taking a medium-term view of these companies.

Hayden Briscoe: We are bullish on the Chinese stock market. The surprise factor this year from a macro perspective could be a manufacturing renaissance, as I see a pickup in South Korea, Japan and Taiwan in the last few months that are usually precursors for China.

There are some nascent signs that long-term value investors such as institutional investors and central banks are contemplating a return to the Chinese stock market. We think a lot of capital could be reallocated there this year, not just from global investors. When market sentiment does turn, the first move could come from emerging market and Asian investors, and H shares could take off before A shares. For domestic investors, it is important to note that deposit rate is at an all-time high. Once there is momentum in the A share market, a large amount of capital could be at play, especially when the property market is down.

From the sector perspective, we are investing in state-owned enterprises (SOEs) on the manufacturing upgrading cycle theme. We see the artificial intelligence (AI) theme continuing this year but probably at a slower pace. We also agree on the China going global theme with an emphasis on car, technology and logistics companies.

Barry Gill: Stock-bond correlation moving from negative to positive has been a big topic in western markets over the last few years, but so far it has not been a feature in China. Why is that and do you expect the negative correlation to continue?

Hayden Briscoe: It sounds funny but to me the West is looking more like China and China is looking more like the West. The West particularly the US has used fiscal policy to prop up the economy during COVID, whereas China has turned to monetary policy instead. China’s bond market has reached the scale to be able to influence the underlying economy, and even though monetary policy actions take longer to have a boosting impact, they are less likely to fuel runaway inflation. The West is dealing with persistent inflation above 3%, under which the stock-bond correlation tends to go positive and is currently at one. China on the other hand does not have this problem. The Chinese bond market is the world’s best-performing sovereign bond market in the past two years, and Chinese bonds continue to be negatively correlated with Chinese risky assets.

Should China be going through a longer cycle due to monetary policy, a multi-asset solution with a five- to seven-year horizon could mitigate the sharp ups and downs in the short term, especially when inflation is subdued and the stock-bond correlation remains negative.

Barry Gill: What role should Chinese assets play in a global portfolio? Are global investors making a mistake by down-weighting now?

Dr. WANG Qing: Cutting exposure to China assets as a short-term tactical move makes sense to me. By my estimates the risk-free opportunity cost of investing in the Chinese market for international investors is over 10% (if the funding currency is US dollar and if the US money market yields 5%). With the funding cost at such a high level, it is only natural for investors to expect much higher compensation for risks from China assets.

But what puzzles me is the global narrative that somehow China has become uninvestable for structural reasons. While it is not easy to disentangle structural factors from cyclical factors, the current market pain can be explained by 70% cyclical and 30% structural factors in my view. As a China specialist investing here for nearly 30 years, we have always been able to generate alpha, even under weak market conditions. From what I can see, many were here for easy beta and the rising tide, which appears to be receding. However, that should not cast doubts on the availability of alpha opportunities. Global investors should take a granular view of the economy and markets in order to identify the many long-term secular growth opportunities. Focusing too much on the short-term macro environment could distract from factors that are more relevant and important to returns.

Barry Gill: Investors fret about slower economic growth in China but at the same time the stock market has never really correlated with the growth of the economy. Is the slowdown in the economy broad or narrow in your view? Do you think that GDP growth structurally downshifting is necessarily bad for stock market returns? Consider this: if you put USD 100 into the Chinese stock market 30 years ago, it is worth precisely USD 100 today, despite tremendous GDP growth during that same period.

Dr. WANG Qing: I do not think an economic slowdown necessarily equals poor returns for equity investors. Last year’s slowdown in the economy was broad based, hurt by tight policies and a weak external environment (both cyclical factors) as well as a struggling property market (structural factor). The collapse in housing market activities and fears of possible spillover effects drove most of the equity valuation compression and downturn then. Yet there has been little contagion so far, and the bulk of the housing correction has already taken place in my view, becoming less of a drag on growth.

In a sense it is a tale of two economies. The property sector and related industries will probably continue to struggle, but sectors that are outside will fare better under a now reflationary policy stance. Ultimately, Chinese stocks can perform well in spite of a so-called structural slowdown due to the property market, especially given the already significant declines last year. Any positive earnings surprise could in fact trigger a rebound from the current low levels.

Barry Gill: About a year ago, the Australian Strategic Policy Institute in a research report highlighted how China is a world leader in many of the 44 identified critical technological areas from an R&D perspective. Can you talk to us about how you see innovation unfolding on the ground in China and how you take advantage of the opportunities?

Dr. SANG Jun: Technology is a priority focus for China and the country had made substantial investments and great strides in the many strategically important and high impact areas that the report has highlighted, including advanced materials and manufacturing, energy and environment, biotechnology, gene technology and vaccines, as well as sensing, timing and navigation. China as an emerging economy has been well positioned and exceled in applications of technology, or “One-to-N” innovations – adapting research breakthroughs into successful systems and products that can be manufactured in scale and cost efficiently with its production capabilities.

That said, developed markets such as the US are leaders of “Zero-to-One” innovations, fundamental breakthroughs that are the result of a long history of dedication to pure sciences and foundational research. It is not a bad thing that China and the US are concentrated and delivering on different areas. For example, the breakthrough technologies for solar energy and electric vehicle battery did not come from China, but we were able to develop the right applications and perfect the production and processing, which put China in dominant positions today.

For generative AI, it is no surprise that breakthroughs so far have come from the US. Partly because of hardware bans as a product of the tensions between China and the US, there is a big gap in building and training large language models (LLMs) that power chatbots and more. As an alternative, Chinese companies are focused on small models and the improvement in applicability and usability, and at the same time try to combine AI with manufacturing and production. I see AI as a growth driver for China. With the highly anticipated ChatGPT 5.0 release from Open AI, Chinese companies will likely develop applications for it. In addition, some are exploring ways to combine smaller models with larger models to deliver a more scalable solution.

Although China is currently behind in “Zero-to-One” innovation, it has built the foundation to be the world’s leading science and technology superpower. Changes in the education system and a shift toward pure sciences and foundational research will further support China’s drive for innovation. That is positive for global investors.

Barry Gill: How important do you think it is that the regulator of the state-owned enterprises introduced return-on-equity (ROE) as a performance metric for the first time last year? If the management of SOEs do not financially benefit from improving profitability – i.e. the principal-agent problem – will this really have any impact?

Dr. WANG Qing: There is a broader backdrop for this new profitability KPI. The overall fiscal position of the Chinese public sector had deteriorated quite a bit in the last couple of years because of low land sales revenues amid the property market plunge. There is an urgent need to find an alternative source of funding, and therefore improving profitability and overall financial positions of SOEs became a high priority. I believe SOE leadership will take this seriously.

I liken the situation to be similar to the IMF. I spent a few years at the IMF early in my career, and my colleagues there had a very strong work ethic, arguably harder working than any investment banker in the West. One of the reasons is that they were very well paid by the civil servant standard, complemented by a sophisticated performance appraisal system with incentives that are not strictly financial. The call to serve the public does not automatically exist in entrepreneurs, so comparing SOE management to entrepreneurs is in a way like comparing apples to oranges. IMF staff delivered high quality work, and I believe SOE leadership could too.

Dr. SANG Jun: The focus on profitability is important. As SOEs evolve over the years, it is not just about costs anymore. They are expected to provide products and services to the people as well as supporting different industries on behalf of the central government – and do so profitably. Because of the possibility of improvement in ROE, many companies have started to increase and compete to increase the minimum dividend payout ratio, which may stimulate stock price increases. The improvement of corporate profitability, corporate governance and valuation level have formed a virtuous cycle. Overall, my outlook for SOEs is positive.

Barry Gill: To wrap up today’s discussion on China investing, what is the most mispriced opportunity that you can spot today?

Dr. WANG Qing: Besides overall H shares as the casualty of the China being uninvestable narrative, I want to call out some cyclical stocks as mispriced. They are able to pay high dividend yield because they are at the peak of their earning cycle; they are not high quality defensive stocks, in my view. This particular mispricing reflects the extremely weak sentiment among investors, who are paying too much premium for short-term certainty and not sufficiently accounting for quality and earnings sustainability.

Dr. SANG Jun: Chinese consumption stocks were darlings when COVID prevention and control policies were first lifted but have since fallen into a rout on weak spending. I believe they are mispriced. Taking the food and beverage industry as an example, which has very low capital expenditure now that the products and manufacturing process are fully developed and in place. Keeping costs down and paying out consistent dividends should be enough for their stocks to deliver attractive returns at low risk levels. This reminds me of some of the successful Japanese liquor makers in the past 30 years.

Hayden Briscoe: We believe income is mispriced, and we are just starting to buy that for the first time in a while. We see the second half of the year as more risk on, which could be supportive for high income strategies.