As Canadians locked their doors to avoid the freezing temperatures this winter, many settled back and watched the action unfold in China. But, at times, it was difficult to tell the bigger story. Was it which athletes made the podium, how many times Xi Jinping cozied up to Vladimir Putin, or was it the growing number of reports explaining the slowing Chinese economy?
For a number of years, investors have been told they are underweight China. The country is, undoubtedly, the growth success story of the past few decades and, measured in U.S. dollars, its economy is 30 times larger than 30 years ago. Recently, its initial response to the pandemic appeared effective with strict lockdowns and an adherence to conventional monetary policy, while the West was forced to unleash record-breaking stimulus packages.
Yet, in recent times, cracks have appeared. China has struggled to maintain the pace of its exports as the U.S. trade war, COVID-19 and now inflation take their toll. It also has a debt problem, highlighted by the plight of property developer Evergrande. The combined effect means China is heading for a slowdown, with the IMF projecting that its economic growth will be 4.8% in 2022, compared to 8.1% in 2021.
The country’s new era of consumerism and expanding middle class has eased the burden on its traditional growth model of exports and industry, infrastructure and real estate investment. It was never going to replace it overnight – a balance was needed, but this has proved hard to achieve. A major reason is the excessive debt in the property sector and many fear that if the bubble does burst, it could spark a prolonged downturn that not only harms China but damages the global economy.
To that end, the government has been pressuring major companies to reduce their debts, while also restricting borrowing and cracking down on informal lending. By showing its willingness to let Evergrande default, it sent a chilling warning to borrowers.
So, on one hand, China wants to encourage business and spending yet, paradoxically, its interventionist approach is stifling. Are entrepreneurs and innovators encouraged by the crackdown on e-commerce giants like Alibaba (an investor favourite), for example?
The case of Jack Ma, Alibaba’s rags-to-riches founder, is symbolic of the recent battle between public and private power as Beijing bares its teeth to rein in the country’s tech titans. In 2015, Ma pressured regulators to retract a critical report on his company, while five years later he spoke out against China’s state-owned banks. Regulators swiftly questioned Ma, halted the IPO of Alibaba subsidiary Ant Group, and humiliated the wealthy entrepreneur. He has barely been seen in public since.
Other firms, like tech behemoth Tencent, food delivery app Meituan and ride-hailing app Didi, have also had their wings clipped by anti-monopoly regulators – somewhat ironically, it could be argued, given the one-party system – cooling investment, innovation and economic growth. Xi Jinping wants “common prosperity” and to close the wealth gap, and this hardline approach looks set to continue. In August, China unveiled a five-year plan, which included tighter control over the economy and areas of importance, like national security, technology, culture, and education.
Despite this internal crackdown, China still wants a seat at the global trade table. Its Belt and Road Initiative, for example, aims to drive infrastructure development around the world in exchange for closer ties with Beijing. There is an internal ideological battle going on. How does it foster business relationships with the like of the U.S. and Russia en route to becoming the world’s biggest economy, while maintaining tight control of its economy and people?
In terms of reputation, China has human rights questions to answer. Its totalitarian government is notoriously ruthless and, typically, not open to negotiation. Look at their treatment of Uighurs or opposition supporters in Hong Kong.
Yet, the West is also partly responsible for being guided by lazy Cold War narratives, and the media’s depiction of the country is often influenced by dated perspectives. Tyler Mordy, CEO and CIO of renowned macro investor Forstrong Global, believes that, from an investment perspective, trying to draw a line between China and America is a waste of time. His thesis is that the two countries are so tightly stitched together that economic decoupling is impossible.
He explained: “There is a level of what we call conscious decoupling happening in terms of their differing ideologies and systems, but the fact remains that it's in everyone's best interest to try mutually beneficial economic approaches first.”
Reason for investor optimism
Some investors will admit they can’t digest the prospect of ploughing capital into China and, by turn, its communist rule, however much the country has leaned into consumerism in recent times. Others take a more dispassionate position. The “regulatory reckoning” of 2021 hit share prices, with the MSCI China Index declining 19.1%, but China bulls see the clouds parting.
With the shock of the crackdown now over, there is potentially a clearer road ahead for the country’s leading e-commerce and tech companies. The fresh clarity could be a tailwind and a chance to reset compelling growth stories. In addition, by virtue of being ahead of Western central banks in tightening monetary policy, and unburdened by huge stimulus programs, China has room to support economic demand moving forward.
The other aspect is a human one. China, in a predictable but arguably effect move, has a zero-tolerance policy towards its COVID-19 lockdowns and health rules. This was a major factor behind its subdued consumer spending numbers. We’ve been here before, of course, but could the pandemic be finally heading to its end game? If you believe it is, then freer movement is likely to result in freer spending.
All this points to long-term attractive upside, with volatility an investment opportunity rather than a signal to run for the hills. There are always risks, of course, no more so than in the government’s ability to make quick and unsettling regulatory decisions. COVID-19 variants are still hovering, the property sector’s debt problems are far from solved, and geopolitical risks – whether it’s with the U.S. or Taiwan – persist.
But “regulatory reckonings” are a common part of Chinese business life – and they are also usually followed by sharp market rebounds. There has been a bear market in 17 out of the past 20 years in China; 2021 was not unusual.
Where are the opportunities?
While it may feel counterintuitive given how e-commerce and tech giants like Tencent, JD.com and Alibaba were affected by Beijing, they remain successful businesses, with potentially calmer waters ahead. JD.com has, arguably, shown more backbone than its rivals. While its earnings fell 2% last quarter, sales grew 32% to US$33.9 billion, beating expectations.
Search engine Baid, video sharing site Bilibili and mobile gaming giant NetEase are three more examples of aggressively expanding companies, even if the latter was the subject of negative press attention recently after the death of an employee, reportedly from overworking. As ever with China, ethical issues are never too far away.
Flying under the radar are sectors supported by the government, such as semiconductors, green technologies and consumer brands. Given the staging of the Winter Olympics, for example, sportswear makers ANTA Sports Products and Li Ning will be expecting a bump in profile.
Another area that risks being overshadowed by Tesla is Chinese electric car manufacturing. Li Auto, which bounced back from a seventh-month low in January, trades in the U.S., is a direct competitor to Tesla and has enjoyed sales growth with its hybrid model, the Li One SUV. BYD Co., meanwhile, is the biggest pure play Chinese EV maker, of which Warren Buffett is a long-time investor. Incidentally, BTD Semiconductor recently won regulatory approval for an IPO listing.
These names are merely one tip of what some could argue is an obvious iceberg. But the point is that being underweight the largest equity market outside the U.S. and world’s second-largest economy is a portfolio risk in itself – and there are an increasing number of funds and ETFs that seek to capitalize on this growth opportunity. If you’re willing to tolerate deep ideological differences, and navigate regulatory shocks, there are rich opportunities in this emerging market leader.
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