Schroder Investment Management Limited
The MSCI China Index has fallen more than 30% from peak-to-trough this year after President Xi announced sweeping changes to the way some companies are regulated.
We talked to Robin Parbrook, Asian Equities Fund Manager, on Schroders’ Investor Download podcast about whether investors have seen the worst of the falls and the outlook for investing in China.
Why are the markets down so much?
It’s not to do with economic growth numbers, which have been slightly disappointing. And it’s not really to do with Covid-19 case numbers either in China. It’s all about regulation.
You can see that because the bulk of the falls came in the last two to three months, when China really started talking about how it wanted the education sector to operate. Ultimately, China has turned the bulk of its tutoring education sector into a non-profit sector.
That was a wake-up call for investors about regulatory risks in China.
Now you’ve had this series of announcements, which are a combination of a whole set of policies that have been building up for some time.
Looking at President Xi’s speeches over the last three or four years, there’s been a lot of talk about common prosperity, levelling up, social mobility, financialisation risks and dual circulation policy. By that we mean becoming more self-sufficient in key strategic industries.
But the surprise has been how quickly they’ve moved to regulate many key sectors in China. This is obviously in particular the internet sector, which is the one for most American investors that gets the focus because many of the stocks are US listed. But it also applies to the insurance, healthcare and real estate sectors.
It is quite all-encompassing and a big structural shift in the market.
Have we seen the worst of China’s stock market performance?
It’s hard to say as we don’t know what will happen next.
But the falls are justified in my view because we have seen a much more draconian and harsh regulatory environment than we expected.
However, it’s worth remembering that Chinese shares were pretty frothy in February and March, when you were getting bubble-like valuations, particularly in the internet and biotech sectors. Even if we hadn’t had the regulatory announcements, those sectors looked very vulnerable to a correction.
Having said that, obviously we’ve seen a big correction in stocks like Alibaba, which are close to half what they were worth from their high.
So the bulk of the initial falls are probably due to the big regulatory shock.
But I think people are now aware that you cannot compare Alibaba with Amazon. And you cannot compare Tencent with Facebook, because these are domestic Chinese companies operating in a completely different environment from their US peers.
We’re probably through the worst, but if you’re looking for a rebound, it is likely to be muted. And we are likely to see further announcements, particularly in those sectors.
President Xi and the CCP say they want to get real estate prices down, they want to get healthcare costs down. Most stocks in China are considered, not necessarily state-owned enterprises, but they are beholden to the state so they will be working for the common goal.
We are quite cautious on those sectors which are clearly part of the policy goals towards common prosperity.
How can foreigners invest in China against this backdrop?
Investors can buy Western companies with high exposure to China, like Louis Vuitton, Nike, or Adidas.
Or they can also get their China exposure via Hong Kong Special Administrative Region (SAR) listed stocks on the Hong Kong Exchange, or via A-share stocks on the Shenzhen or Shanghai Stock Exchanges.
Or you buy multinational companies with businesses in China, which could also be things like Schindler or KONE, businesses like that.
What does this mean for investing in the rest of Asia?
There’s a big reset in China. This is something structural, it’s not cyclical and it’s not noise. It does mean you may want to rethink how much money you want to have in China. When you turn your most vibrant part of the economy – your internet stocks and some of your healthcare names – into quasi state-owned enterprises, they do become less interesting.
So the initial reaction has been to see money shifting to other markets in the region. We have seen some money drifting into India.
The bigger one, which we don’t really know, is whether you start seeing investors reviewing whether they need to have so much money in Asia more generally, or in emerging markets.
China is by far and away the largest market in emerging market indices, so investors could start reducing their exposure to Asia and emerging markets more generally.
We haven’t seen that. I’m not anticipating that at the moment, but we are anticipating you will see money looking to diversify out of China.
Some may move into some of the smaller ASEAN (Southeast Asian Nations) markets, maybe back to South Korea and Taiwan, because they are the more liquid markets in the region.
Can you still afford to be in China?
You’re always going to be in China when you’re investing. Assuming you’re buying large multinational companies, they’re going to have exposure in China.
So you can’t ignore China. The question is as an asset class, do you need to have a big strategic asset allocation to Chinese equities?
There’s some fantastic companies in China that are broadly unaffected by the regulatory risks of the consumer companies. Some of the export companies, some of the tech companies – they aren’t the focus of what’s happening now.
But for a global investor, an investor sitting in the United States, do you need to have a big strategic asset allocation to Chinese companies? Probably not, because the big Chinese companies, the banks, insurers, possibly some of the internet companies, aren’t particularly interesting when you’ve got common prosperity goals, dual circulation policies and a very interventionist government.
Beta – a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole – from China is probably relatively less now. So buying an index fund in China doesn’t make much sense.
But there’s lots of opportunity because the market’s inefficient. I would look at it that kind of way: that you want to buy a really good active fund, but don’t go overboard in how much you want to asset allocate there. Because the risks, which were always there, have now risen materially on the regulatory side.