In this 12-minute video, Siguo Chen from the RBC Asian Equity team provides insight into what’s driving the recent volatility in Chinese equity markets. She also provides updates on:
She also shares her thoughts on the benefits of an allocation to China in investment portfolios as well as where they are seeing opportunities in China today.
View transcript
What’s driving the recent volatility in Chinese equity markets?
Regulatory headwinds have been building up for a while.
The most significant one is internet. And that’s the reason—that’s the very reason basically why we went underweight quite significantly since earlier this year, which turned out to be the right call.
I guess, the regulatory changes are broad based and impacting multiple sectors, not just internet. I think some of the measures are mildly disruptive, but there’s no two ways about it. And some of them can be quite destructive.
If you look at after-school tutoring centre, tens of billions’ worth of market cap were wiped out in the space of one day. But for the most prominent one, the regulations on the internet sector, I think these anti-monopoly rules are not too dissimilar to the intentions of, let’s say, the policy makers in the Western markets.
The key difference with China is that their capacity to implement sweeping reforms to sectors without much communication, or much communication beforehand, or basically, speak to investors or shareholders; while in direct markets, where you see these things are yearly carried out, implemented by legislations, and you will see a lot of consultation in market communications.
But that’s not the case with China. And lack of transparency, lack of visibility, that’s the key difficulties for a lot of investors and, I think, a big driver to this volatility.
How have regulatory actions by the Chinese government affected markets?
So, the questions now are, first, how much of these changes are reflected in the price, and second, how much more to go in terms of pipelines.
Sentiment has come under a lot of pressure for the tech names, mainly because there’s still a lot of uncertainty. But if you look at the valuation of, for example, Tencent, a company with multiple growth drivers and double-digit earnings growth. And, I mean, if you look at the sum of the parts of the investments—already make up about 40% of its market cap. And it’s only trading at high-teens multiple now.
On the other hand, of course, it’s hard to determine the full timeline of the upcoming regulatory announcements, but we can certainly frame it around some key events. The most notable would be the, I think, 20th Party Congress next year. To us, that points to a reason why they’re being so aggressive in pushing regulatory actions this year. And, therefore, going into next year, you could see a normalization of regulatory announcements in order to—from the government—in order to avoid too much volatility, not just in the market, but overall speaking.
So, with respect to our positioning, I think we’ll be actively watching various policy signals towards the end of the year.
What is your approach to investing in state-owned enterprises (SOEs)?
Broadly speaking, I think it’s true that Chinese SOEs don’t have as good operational metrics nor investor returns and tend to be value destructive.
For instance, for Sinopec to produce the same output as a company, say, ExxonMobil, they would be employing four times the employees compared to ExxonMobil. And some of the Chinese banks have similar issue with their capacity capital allocations as well.
So, we’re aware of these differences and we try to avoid the inefficient SOEs. But saying that, we don’t necessarily discriminate against them. When an SOE is efficiently run and professionally managed, it can be a very good investment target.
A good example would be, one SOE I can think of we invested in since inception of the fund is the largest power grid automation company. It has very stable earnings growth and ROE of mid- to high- teens, and it’s yielded great results for us.
What is your outlook on Chinese company IPOs on North American exchanges?
So, the pace of Chinese companies’ IPO in the U.S. has slowed massively. You have, basically, increasing legal risk of being delisted or pressured from the U.S. side, or political risk of choosing to list in the U.S. instead of in China from the China side. And also, overarching geopolitical risk, tension between the two sides.
I think there will be fewer Chinese companies to choose—for them to choose to list in the U.S. That’s almost a given.
Now, the natural alternative is to list in Mainland China or Hong Kong. And Hong Kong—it gives access to companies, to institutional investors, U.S. dollars, international markets. That will remain the case.
But also, increasingly, the Chinese government, they are promoting new venue for listing. For example, China’s STAR board, and now they’re talking about exchange in Beijing. And I would say, there are very good companies that are listed only on the Mainland China onshore markets. For example, the bulk of the EV, the electric vehicle battery supply chain, 80% of that global supply chain is in China and they’re mostly listed onshore.
I think we will just have to look more broadly, and we invest indiscriminately anyway on different exchanges.
What are the benefits of an allocation to China to your investment portfolio?
Now, I think, I’m sure you’ve heard this before—the benefit of investing in China involves diversification benefits, exposure to the second largest and fastest-growing economy, right in middle-income class, improving ESG and disclosure; all of that. Those are factors most people would agree upon. They still remain valid and good reasons to keep allocations in China.
The question now, I think, is, in light of the regulations we’ve seen and deleveraging happening in China, does that still leave good opportunities for us to invest in the region.
I think one thing I’d like to point out is that people have been focused on large cap, which also happen to be the ones that are impacted the most by regulations. For example, if you look at the broad index, MSCI China was down 16% year to date, mainly dragged by a few big-cap names like this. But if you look at CSI 500, which is also a broadly quoted A-share mid-small cap index, there you can see a positive return of 16% year to date.
I think that’s a good indicator epitome of the depth of the economy, and also the depth of the market. The sheer diversity of it; many sectors and thematics we can choose from, and most of them are less covered than their Western peers.
There is policy risk, for sure, but there’s equally policy tailwinds as well for a lot of the sectors, such as renewable energy, semiconductor consumption. And that’s where the opportunity lies for us.
Where are you seeing opportunities in China today?
At the moment, you’ve got, obviously, the new economy, which is renewable energy, electric vehicle, and some of the high-end manufacturing. And also, the old economy, which is oil and gas, property, financials. And, obviously, the opportunity will be mostly in the first bracket.
But going back to the thematics, things we’ve talked before, is one key benefit of investing in China is the diversification benefits. And China is not—actually, now, China is probably one of the very few markets that’s not trading at its all-time high. You can actually get in with lower and more reasonable valuation.
There’s obviously reasons behind that. But as we get to the end of the bulk of the regulatory overhaul, let’s say if U.S. markets sell off, which market I think will be most insulated from that, at this point, I think the answer is China.
And if you think about—there’s actually, if you look at 2018, what happened, there’s a very similar setup. China had a sell-off in May, I think, as the markets—you know, the part of the deleveraging outcome is starting to show, and the trade war escalated at the same time as regulations on the gaming sector. So China sold off in May, around May.
Once we got to the end of 2018 when U.S. markets started to sell off—tightening financial conditions, higher rates, there is the credit element to that as well. But when that happened, China was among the most resilient market during that sell-off. So you do see the benefit of diversification there as well. So that’s the near-term dynamics.
On the longer-term perspective, we’re looking at the structural drivers we mentioned before, and also, changes—one of the main major politic is that we see Chinese household wealth allocation shifting more towards equity. Currently now, that’s only about 11% of the household wealth. In equity, we’re seeing more of that shift from property, which is about half now, into equity. And that will be one of the main tailwinds of the Chinese equity markets.