- Rather than anti-capitalism, China’s recent regulatory crackdown was due to its lack of progress in transitioning its economy into a consumption-driven one.
- Moving forward, we see sectors part of the country’s “Three Big Mountains” – education, healthcare, and housing – will continue to be at risk of further regulatory tightening, given their significance in influencing the cost of living.
- We believe that the domestic A-share market is better positioned for the Common Prosperity theme, particularly in the short term, and doesn’t lose out in terms of long-term prospects either.
- While we acknowledge that China equities may be volatile during this period given the fluidity of the Evergrande situation, we approach investing in China based on its massive long-term growth prospects.
- The profile of the A-share market, with its inefficiencies, advocate for an active approach, and we recommend the Allianz China A-shares Fund for value-seeking investors brave enough to take the plunge.
This unfortunate twist of events has led to China being the worst performing major market in 2021 – a stark contrast to the optimism earlier this year.
With regulatory risks notoriously hard to forecast and predict, what’s next for Chinese equities?
Figure 1: Plagued by regulatory fears amongst other reasons, Chinese equities have flattered to deceive in 2021
Not enough: Despite improvements, China’s still far behind its peers in growth transformation
China's government’s intention was clear right from the start: to transition the Chinese economy into a consumption-driven one instead of relying on exports and investments – all done without sacrificing economic growth; most of us just haven’t been very attentive.
Yet, progress in such efforts over recent years had been middling at best.
In a study by World Bank, China’s final consumption expenditure as a percentage of GDP stands at 56.0%, and while it has risen much since 2010, it remains well short of its peers. By contrast, other economies, like Brazil (84.8%), India (71.7%), and the US (81.8%) have significantly higher ratios, showing the enormity of the task at hand. It’s also unfortunate that its transformation efforts were consistently thwarted by external events outside its realm of control – trade tensions with the US in 2018/2019, followed closely by the COVID-19 pandemic in 2020/21.
Figure 2: China’s transition to domestic consumption continues to lag behind its peers
Still far from achieving its objectives, it then comes as no surprise the Chinese authorities have opted to intervene directly in the form of the recent regulatory measures. Their solution to this issue, as highlighted in the recent 5-year plan, is twofold: one, to double down on increasing the proverbial pie through innovation; and two, to ensure that the pie is more equitably distributed amongst its sizable population.
While intervention by Chinese policymakers has been heavy-handed and clumsy at times (like the last-minute suspension of Ant Financial’s IPO), it has been thematically consistent over time. Unlike most mainstream media outlets, we disagree that intent was anywhere near as anti-capitalism (or the CCP flexing its authority) as they have portrayed these measures to be.
Deciphering China’s evolving regulatory landscape
Many of its new regulations can loosely be sorted into two main categories: (i) Anti-trust measures, (ii) Social equality.
The first basket consists of anti-trust measures, which account for most of the regulations announced thus far. These measures targeted at Tech giants like Alibaba and Tencent were designed to reduce the monopoly power of these massive conglomerates.
There are strong parallels to be drawn here, with the concentration of power amongst the biggest tech companies in their respective markets - Alibaba and Tencent in China, the FAANG stocks in the US - are concerning to authorities on both sides. Many of these companies essentially run the marketplace that they operate in (eg. Facebook in Social Media, Amazon in e-commerce), with regulations (particularly regarding virtual assets like data) still playing catchup, these companies have an overwhelmingly unfair advantage, ultimately stifling innovation and competition in the industry.
But here’s where China and the US draw the line. Rather than waiting years, if not decades, debating in congress on how best to approach the issue – China has opted to intervene first and tweak its approach along the way (eg. outlawing “picking one from two”).
The second basket is labelled Social Equality – structured around resolving the social issues that China has developed since opening its doors to outside world. Compared to their developed market counterparts, Chinese citizens have historically felt less assured regarding their access to necessities such as healthcare and housing, resulting in a higher propensity to save (43.8% vs US’s 18.7%) as to create a safety net to prevent financial disaster from any unforeseen circumstances. Such a high savings rate is one major obstacle in China’s transformation towards a consumption-driven economy model.
Aside from that, higher costs of living and raising children have resulted in plunging birth rates – exacerbating China’s ageing population crisis. This troubling concern also formed the basis behind the recent clampdown of the For-Profit After-School Tutoring sector.
Figure 3: Building up a safety net – China has one of the highest
saving rates in the world
China’s Three Big Mountains
Looking forward, sectors part of the country’s “Three Big Mountains” – education, healthcare, and housing – will continue to be at risk of further regulatory tightening, given their significance in influencing the cost of living. By mitigating the costs of living and through regulation and changing the Hukou (户口) system, the Chinese government ultimately seeks to increase income stability and manage living costs, potentially encouraging citizens to increase their domestic spending.
While the tech crackdown has dominated the headlines, under the hood, evidence of a growth slowdown in China is starting to mount. Various indicators – exports, retail sales, and fixed asset investment numbers, have all missed expectations recently, and perhaps more worryingly, the Caixin China August PMI* data came in at 49.2, reflecting a contraction of the goods & services sector for the first time since the pandemic last year. This economic slowdown is the result of a confluence of various factors – the resurgent delta wave, slowing exports (a result of slowing global growth), and most notably, the tightening in the property sector (which consists of ~25% of the Chinese economy).
*PMI: PMI, or Purchasing Manager’s Index, is a measure of the prevailing direction of economic trends in the manufacturing and service sectors as viewed by purchasing managers. A PMI reading of less than 50 indicates a contraction in the economy.
Slowing growth, coupled with the unprecedented regulatory overhang does not paint a pretty picture. While intentions behind the regulations are clear, consistent, and good-natured, they have undeniably have affected the fate of future growth and profitability of the affected companies, and by extension the greater market as a whole. With many high-profile investors (such as George Soros) declaring China uninvestable, should investors be worried?
Figure 4: Caixin China PMI reflects slowing business sentiment
Acknowledge
the noise, but focus on the big picture
That said, we recognise that things could be messy in the near term – considering China’s perchant for a heavy-handed approach. China’s relatively benign investment landscape before the crackdown has lured many investors into complacency, with many having forgotten that China equities have arguably always been a high-risk, high reward play.
However, we believe China remains an attractive investment destination from a longer-term perspective. Fundamentally, what made China such an exciting investment opportunity has not changed, and we expect the worst-case scenario – a full-blown nationalisation – to be highly unlikely if the Chinese government wanted to hit its lofty growth goals. Furthermore, with some of these regulatory changes potentially boosting domestic consumption in the long run, this might even have strengthened China’s case as an attractive investment opportunity. Coupled with its cleaning up of the financial sector, this points to a more sustainable, healthier, Chinese economy.
While we believe that it may be premature to call an end to the headline-grabbing regulatory headwinds, there is potentially another catalyst in play – as China has seemingly moved into an easing cycle. Chinese authorities are well aware of the consequences of their actions on the broader economy, and with evidence of the growth slowdown mounting, have already begun implementing policies to stabilize growth.
Despite maintaining a tight leash on certain sectors (i.e. property and tech), they have loosened both monetary (additional liquidity injections via reserve requirement ratio cuts) and fiscal (additional financing for SMEs) stances. Just as global economies are tapering and tightening in general, China could be doing the very opposite – creating an attractive opportunity for investors.
*Reserve Requirement Ratio: Reserve Requirement Ratio, or RRR, is a regulation that sets the minimum amount a bank must hold in liquid assets. A reduction of the RRR means that banks can issue more loans (all else remaining equal), increasing liquidity in the market and encouraging lending and investment.
Beijing’s bifurcated approach of general easing and targeted tightening means that we would likely see an uneven response within the Chinese market; different sectors are expected to benefit differently.
While China as a whole remains an attractive proposition for the long term, we believe that the short-term risk-return characteristics are heavily skewed in favour of the onshore Chinese market.
The domestic A-shares market is well-positioned for the ‘Common Prosperity’ theme:
- Lower exposure to sensitive industries: The most obvious difference in market allocation would be to China’s biggest software companies. Even outside of Tencent and Alibaba’s sheer scale, its other Internet company peers (JD, Meituan, Baidu to name a few) all possess sizable influence in highly concentrated industries, and some (such as Meituan and its gig economy) are potential roadblocks in the Chinese drive for common prosperity. These companies are hence more vulnerable to further potential antitrust regulations. In addition, the onshore China market has a slightly lower allocation to real estate (2% vs 3.6%), which is poignant considering the ongoing vulnerability of the Chinese Real Estate sector.
- Higher Exposure to Potential Government Stimulus: While monetary easing (eg. RRR cuts) is likely beneficial for the economy in general, fiscal stimulus from the government is likely to benefit companies unevenly. Yet again, we refer to the Chinese 5-year plan for reference – and we believe that Tech Manufacturing (Semiconductors, 5G infrastructure), and Green Initiatives (Solar Panels, Electric vehicles), as well as the raw materials required to manufacture them, stand the most the benefit from this stimulus. This favours the China onshore market as well, without the Tech giants dominating the index, we see higher allocation to all the aforementioned sectors.
Read More - China’s semiconductor industry: A sleeping giant that has been awakened
Figure 5: Sector Breakdown reflects A-shares’ lower vulnerability to regulatory risk and higher sensitivity to potential stimulus
Figure 6: Aside from SMIC, the majority of
China’s semiconductor companies are listed onshore 
In the long-term, the China A-share market makes a strong case for inclusion in any investors' portfolio as well. While the Chinese authorities are actively working to increase accessibility to the A-share markets, it is still currently severely unrepresented (China constitutes 16% of Global GDP yet only 4% of the MSCI ACWI Index, and A-shares are ~65% of China’s overall economy), which has two key implications:
- Low Global Correlations: In addition to being underrepresented (which reduces global index exposure), China A-share markets also generate most of their revenue domestically. As recent events have demonstrated, China also faces a unique and different political and economic mix than most of its global peers. Combined, the result of which is that China A-shares exhibit a lower correlation to most global equity markets, and could hence provide a potential diversification option for investors.
Figure 7: China A-shares serves as a potential equity diverisification option for your portfolio
- Potential for Increased Inflows: China’s continued attempts to open up its financial markets is making good progress thus far, with MSCI increasing the inclusion of China A-shares in its global indices and Blackrock’s recent foray into Chinese markets 2 significant milestones. With further steps being taken to continue increasing the accessibility to the onshore markets China A-shares could attract higher further foreign participation, leading to high demand and potentially price appreciation for this underrepresented segment.
With this in mind, how should investors invest in China A-shares?
Active approach is best for an
underresearched, relatively inefficient A-shares market
Investors seeking exposure to China are encouraged to adopt an active approach. With the Chinese A-share market dominated by retail investors, there is an overall dearth of research within the space. Combined with the unprecedented regulatory climate, there will certainly be inefficiencies and opportunities for fund managers with the expertise to take advantage of.
For this, we recommend the Allianz China A-shares Fund.
About the fund
The fund is managed by co-lead portfolio managers, Anthony Wong and Sunny Chung. Anthony and Sunny work very closely with each other from idea generation through to stock selection and portfolio construction, following the same criteria of growth at a reasonable price. They are supported by an experienced team that specialises in China and Hong Kong markets, working closely with the China equity portfolio managers.
The team has core expertise regarding stock selection and portfolio construction, such that stock selection is both the key driver of risk and return. Through a combination of strong stock-picking overlaid with effective risk management, they believe that market inefficiencies in Chinese equities can be harvested into capital returns.
Why do we like about the fund?
The fund provides access to China’s long-term growth drivers, and it focuses on the following key themes:
This is in line with our view that opportunities currently exist within the A-shares space in these particular themes (notably technological self-sufficiency, renewable energy, and domestic consumption), and more importantly, in line with the Chinese government’s 5-year plan. To play into this theme, the fund is currently overweight in consumer and material sectors while being underweight in Financials and IT (as of 3 September 2021).
In addition, we also like that the fund does not have any market cap restrictions and invests across all market capitalisations. With improving the prospects of smaller companies being one of the key goals of the Chinese authorities, this flexibility in investment mandate could provide the fund manager opportunities in yet another segment in the government's good books.
In light of the recent news, we would also like to mention that the Fund has no exposure to Evergrande as of end August 2021.
The Allianz PM team is of the view that the property sector represents a small part (2-3%) of the China equity market looking at MSCI China A and MSCI All China (Figure 5), and regulators have likely judged that the risk is non-systemic. Instead, the PM team believes that Evergrande will serve as a warning to the rest of the property market to stay in line. On the positive end, this could also mean additional easing measures from the Chinese authorities.
This tactical position has meant that while the fund is still in the red on a YTD basis (-4.64%, as of 20 Sep 2021), it has outperformed its China A-share peers, and has outperformed the other Chinese equity funds on our recommended funds list as well. With potential positive drivers on the way, we believe that the fund is well-positioned for success.
Figure 8: The fund has outperformed the other recommended funds & ETFs in the China equity space
China A Shares market – riding on the tailwinds of Common Prosperity
With many equity markets globally all near all-time-highs, China stands in stark contrast to its rivals after a grueling 2021. Current valuations are justifiably depressed as investors digest the implications of the new regulatory climate, and with the crackdown still ongoing, investors are certainly not out of the woods yet.
Ultimately, we are still optimistic about the long-term prospects of China. The longer-term outlook remains attractive, and potentially even stronger after these regulatory changes, and we believe that the beleaguered Chinese Tech sector will continue to have a key role to play. However, trying to predict the end of the regulatory storm is a fool’s errand, and the lack of other near-term catalysts suggests a potential long period of consolidation as these companies lick their wounds.
Unlike most of their H-share counterparts, a larger proportion of the A-share markets are firmly in the government’s good books, and are well-positioned to benefit from potential further easing measures. The long-term prospects remain bright as well – while not Tech firms, they are key cogs in China’s future. Given the fluidity of the Evergrande situation, we acknowledge that China equities may be volatile during this period. However, we approach investing in China based on its massive long-term growth prospects, and in a global equity market perched at high valuations – China A-shares might be an opportunity for value-seeking investors brave enough to take the plunge.
Investors seeking to gain exposure to the China onshore market now are encouraged to adopt an active approach via our recommended China A-shares fund –Allianz China A Shares Fund.
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