As first in and out of the crisis, China has led the way in the recovery from the COVID-19 pandemic and its resilience is reflected in the outperformance of its equity markets versus other markets globally. In the year to date, the MSCI China All Shares (+22.1%) has outperformed the MSCI ACWI (+4.7%), as well as its peers in Asia (+9.2%).
Despite this outperformance, valuations remain at a discount to other major equity markets (Chart 1), with stronger support relative to global peers in the recovery of corporate earnings and economic growth.
THE CHANGING FACE OF THE CHINA OPPORTUNITY
One of the drivers behind China’s resilience is its transition to a new normal where domestic growth and self-reliance is now a focus. Long underway is the rebalancing of its economy away from exports to consumption, helped by the rising wealth and sophistication of Chinese consumers, alongside the transformation of its vast rural economy.
Reflecting this progress, Chinese exports as a proportion of gross domestic product (GDP) are below 20% today, about half the level of 15 years ago. For investors, this presents an opportunity to get involved in the take-off of Chinese consumption growth, particularly as the economy recovers from the impact of COVID-19.
Despite an ageing population, there are many tailwinds for the consumption-led opportunity across multiple sectors in China. Rising affluence coupled with the propensity to upgrade purchases are supported by growing evidence of strong underlying growth in sectors such as healthcare and protection insurance. It is also reflected in the propensity of an increasingly wealthy population to upgrade their purchases to products perceived as higher quality, namely ‘premiumisation’. One example is in the high-end baijiu liquor market where inventory levels have normalised post the pandemic and the wholesale price is showing some strength, which suggests solid demand.
China’s pivot from industrial to innovation-led services means the levers of growth are driven more by technology than labour. This mitigates the potential demographic burden as the working age population peaks. This trend has been accelerated by COVID-19, as China has increased “new infrastructure” investments to boost long-term productivity by leveraging next-generation technologies, such as 5G base stations, artificial intelligence (AI) and datacentres, intercity high-speed railways, industrial IoT, ultra-high voltage grids and electric vehicle charging stations.
BUILDING TECHNOLOGICAL SUPREMACY
Being at the forefront of technological innovation and achieving self-reliance in technology is a key priority for China. The importance of which has recently been validated and accelerated by the rising tensions with the US, as President Trump has placed punitive actions on tech giants such as Huawei and TikTok.
One clear example of such technological supremacy is the accelerated build out of 5G, in which China is arguably the global leader. Another example is the launch of its own Nasdaq-style ‘STAR’ board, a facility that encourages technology companies to list in their homeland.
The scale of the opportunity in China is reflected in the increasing initial public offerings (IPOs) on both its onshore and offshore markets. On the former, the number of A-share IPOs has almost doubled over the past year.
CHINA’S TRANSITION FROM RURAL TO URBAN
China is by far the biggest e-commerce market in the world, yet its internet penetration rate is just 58%. We believe a significant proportion of this penetration gap could be accounted for by rural dwellers– about 40% of the overall population. Disposable income and e-commerce growth in rural areas is now outstripping that in urban areas, allowing rural dwellers greater access to products and services without having to move to a city. China’s transition to a consumer-led economy will be a key driver of domestic growth in the coming decades.
This should create opportunities for investors in ‘new’ economy sectors, such as consumer discretionary, technology and healthcare, which are still relatively underpenetrated compared to developed markets (Chart 2). Alongside the growth of this burgeoning middle class has been an increasing focus on such areas as healthcare and insurance, driven by the country’s unique demographics and technological advances. With greater assets comes the need for insurance to provide cover in the event of losses. Innovative companies that provide solutions – often through the application of technology – to these relatively nascent industries are likely to be long-term beneficiaries of markets that are clearly here to stay.
Case study: Hangzhou Tigermed
This clinical research service provider stands to benefit from two key factors: the increase in R&D spending by domestic Chinese pharmaceutical companies, and the greater level of clinical trial outsourcing by multinational firms. This market has high barriers to entry, and Tigermed has built a strong reputation since inception in 2004. This long-term experience ensures that the company has an excellent network, which will help facilitate further clinical trial development opportunities despite the short-term disruption from COVID-19. With a business model that is asset light, the company generated attractive returns on investment, in addition to healthy cashflows that can be used to invest in organic growth or fund acquisitions. We believe Tigermed is well positioned to capitalise on the continuing advances in healthcare in China.
WHAT COULD STALL CHINA’S ENGINE?
China’s pathway back to growth is set against a backdrop of a challenging global economy. Debt levels will inevitably increase amid expansionary policies, but the systematic risk affecting the overall market is still manageable.
The prolonged pandemic and its impact on global trade could linger and hinder the curve of recovery. However, re-opening of major economies from the lockdown and co-ordinated policy responses could still help to ease the pain.
China’s adoption of a more inward-looking approach, focusing on domestic investment and boosting domestic demand, and achieving self-reliance in strategic industries is also key to building some relative insulation from external factors.
Geopolitics also remains a source of risk for China, such as further escalation of trade tensions with the US.
Further tensions could result in rising supply chain dislocation, restriction on access to top technology, and other pressures on Chinese companies, tariff-induced growth weakness, restrictions on the flow of investor funds from the US into Chinese markets, and potential delisting of Chinese firms from US exchanges. Despite these risks, it is notable that earnings revisions for Chinese companies are faring better than both emerging and developed markets.
GROWTH LOOKS SET TO STAY
So why do we believe that China’s growth engine won’t stall? The Government has stressed its commitment to pro-growth policies. We have seen broad-based monetary and fiscal support so far, including liquidity injections as well as tax cuts.
Going forward, infrastructure investments via an acceleration of local government bond issuance and support for private companies have been part of China’s toolkit.
Apart from shifting the growth focus onto domestic investment and consumption growth (or ‘the inner-cycle’ as the officials put it), China remains committed to deepening the structural reform and opening its domestic economy to foreign investment.
At the beginning of 2020, the foreign investment law, which the National People’s Congress approved last March, took effect.
The legislation aims to give foreign businesses equivalent rights to those enjoyed by domestic firms, ranging from intellectual property rights to the overseas remittance of profits.
Another example is the opening up of China’s capital markets to international investors. China scrapped investment quota limits for Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) in September last year. This year it has lifted the foreign ownership limit on securities and fund management firms. Historically, international equity investors have tended to focus on the offshore market given its more open access and transparency.
Another avenue to consider– especially now it is becoming more open – is the onshore A-share market, which offers direct access to China’s vast and vibrant domestic equity market. It is characterised by market inefficiency due to dominating retail participation, which provides good opportunity for long-term fundamental investors such as ourselves.
Uncovering the most attractive opportunities in China, we believe, requires specific expertise, and a strategic, active approach to generate alpha.
Wenchang Ma is co-portfolio manager at Ninety One (formerly Investec Asset Management).
