China’s recent regulatory changes will set the tone for 2022, as the focus on sustainability becomes increasingly central to the Chinese economy. These actions have upturned sectors like education and online gaming and reined in the property sector — all aimed at addressing the main socioeconomic challenges facing Chinese society today. At the same time, China has announced measures to achieve its goal of peak carbon emissions by 2030, with implications for industrial energy use.
Navigating these changes may be the main challenge for investors in the short term against a global backdrop of rising inflation in the West and prevailing US-China tensions. That said, we continue to believe the long-term case for Chinese equities remain intact, particularly for investors with the patience and flexibility to position across the opportunity set.
In the near term, China’s economic growth may see downward pressure amid slowing property sector activity and power shortages that have led to suspension of production in some regions. While there are reasons to be circumspect on corporate earnings prospects, we also see this environment as an opportunity to accumulate high-quality stocks, as valuations have become supportive in certain sectors. We note that small- and mid-cap companies in the A-share market have outperformed larger ones by about 20% as of September 2021. However, we need to be mindful of the earnings delivery capability of the smaller companies going forward. Meanwhile, we see potential to accumulate industry-leading large caps with solid fundamentals at cheaper valuations. Similarly, the recent correction in offshore China stocks has created some buying opportunities for specific companies, including tech companies.
While there is some uncertainty over whether more regulatory changes are in the offing, we believe the A-share market would carry a lower policy risk premium than offshore markets given that domestic investors typically have higher confidence on policy visibility.
While markets have focused on the selloff, we believe investors should not lose sight of a more important and long-lasting aspect of the regulatory shift: China’s elevation of sustainable business models and strong governance underscores the importance of ESG (environmental, social, and governance) factors in stock selection. Going forward, companies with better ESG performance are likely to be the disruptors rather than the disrupted.
China’s recent regulatory moves have been cast as a rebalancing of excesses in certain sectors that are contributing to the “three mountains” – housing, education, and health care – that can pose daunting challenges to young families. (For more on this topic, see our recent piece, “China’s ‘Three Mountains’ Spur Market-Moving Regulation”). Despite multiple steps the government has taken to loosen its one-child policy since 2014, the fertility rate is still near alarming low levels.
Source: World Bank data, accessed 8 November 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
The pre-school population, which peaked in 2020, is expected to decline notably starting in 2021. The cost of housing and education are the two main reasons why couples are not having children, with spending on these items taking up more than a third of a typical Chinese family’s disposable income (see chart below). Not only do parents spend a lot of money to send their kids to good schools, but after-school tutoring has also become essential, with kids spending an average of six hours per week during the school term and 15 hours per week during the summer holiday on these activities.
Source: National Bureau of Statistics, accessed 8 November 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
Given the implications of demographic problems for China’s labor force, societal makeup, and economic vitality for decades to come, it is no surprise that the government has taken decisive steps to address them , even as it upends the business models of some companies.
In China, 2022 is heralded as a pivotal year– bookended by the Winter Olympics in February and later by the Communist Party’s Congress, an important twice-per-decade political gathering. All eyes will be on the latter for clues to Chinese leaders’ strategic direction. In the short term, investors should navigate the markets with greater selectivity to avoid sectors that are highly impacted by changing regulations and to position in line with the government’s sustainability thrust.
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