Third Quarter 2021 CIO Review and Outlook
Robert Horrocks, PhD, discusses how he navigates and invests in a challenging environment, especially in China amid recent regulatory actions.
There have been few years where the short-term swings in the markets have been (to my eyes at least) more in conflict with long-term trends: a sell-off in tech sectors and health care, a rise in cyclical businesses as opposed to secular growth, and dramatic rallies favouring one country over another.
For the shorter term, 2021 has seen the long-awaited value rotation. In a disinflationary environment, mega-cap growth stocks tend to do well; when economies reflate and yields rise, these growth stocks have their valuations questioned. Cyclical businesses like banks and materials bounce back. Smaller companies enjoy the more liquid environment—all of these effects have been present this year and we have endeavored to take advantage where we can.
The year has been a good one for India, with the one year performance differential with China reaching 60 percentage points (as of September 30, 2021). Why has India been so strong? Well, it’s partly a recovery in earnings growth from the nadir of the pandemic. However, this is not a sufficient explanation, for earnings-per-share have bounced back to a point that seems to me to be above trend. India has seen strong growth in manufactured exports, notably the automotive sector, as demand has recovered in Southeast Asia and Latin America. Is this cyclical? Or is it the start of a growing manufacturing prowess? If the latter, then the recent rise in valuations is well-deserved. And yet it is impossible to know for sure. One should also note that India’s liquidity environment has been helped by the world’s disinflation and by the swing from current account deficit to surplus, which has also supported the rupee. These are all vulnerable to a more reflationary environment and so some caution is warranted.
Japan had a difficult start to the year but as the reflationary pressures have grown, the market got into its stride a bit more. It has been helped by the global rebuild of inventories, as Japan’s manufacturing bias has supported the rebound in factory production. Ongoing trends of automation to improve factory yields also play to the strengths of many Japanese companies. In light of these current trends, Japanese equities have undemanding valuations.
In the rest of Asia and in the emerging markets, it has been the more cyclical business and economies that have tended to do well. As is often the case, Russia has done well as China has faltered. Latin America has rallied, partly because of raw material price rises but also because of some of the same current account effects that India has enjoyed. It is undeniable, though, that Mexico has done much to bolster their external position within the context of a manageable budget deficit.
But it is China that dominates headlines. Over the past few weeks and months, the Chinese stock market has been put under increasing pressure. U.S. -China relations continue to be fraught. China’s own regulators have imposed regulatory costs on some businesses—in some cases to the extent that the vast majority of a business’ profits may disappear. US politicians of all political leanings have denounced financial investments in China and to these polemics has been added the cry that China is uninvestible! Indeed, this is not the China I once knew as a young student in Beijing in the late 1980s.
But is that a bad thing? Either for China or for investors? Not at all. For the China I knew was still centrally-controlled. Educators (my professors) earned only enough to seek out a basic life. Students in graduating class were allocated jobs. My roommate, one of the brighter ones in his class, was allocated a job at the state publishing house, no doubt turning out tedious tomes of tortured tweaks on Marxist-Leninist thought.
But he escaped all that—and China did too. His generation is overwhelmingly employed in private industry (over three quarters of urban employment is in small and medium-sized private enterprise). Incomes have soared, along with home ownership, the ability to own a car, to have access to foreign media, to travel. To be middle class. The stock market averages, burdened as they were for so long with the listed vestiges of old China, do not reflect this incredible story of growth and discovery. But a sensitive, active investor could be part of this wealth creation by selecting businesses in the domestic demand areas of the economy—consumption, technology, health care, financial services and other sectors have all bred domestic champions.
All this effort and determination has been greeted not by applause for the alleviation of mass poverty, rather by fear and suspicion. The West, so long a model for China’s reforms, now seeks to contain China. And China has reacted by reaching out to its neighbors and neighbors once and twice removed to offer the same kind of growth plan—infrastructure, manufacturing, trade, middle class development.
And that is where China finds itself now. After having been told for so long that it’s growth was a mirage (“it’s just low wage exports”), China finds itself facing the demands of citizens that have belied such wrongheaded analysis and who now work jobs in the service industries, finance, health care and technology and who live lives which, in the face of it, are not so very different from our own.
So the current regulatory actions are an attempt to answer the criticism that China’s growth has been oblivious to environmental damage, to health, or that it lacks the right kind of education (too focused on rote learning!) to develop truly creative minds. The Chinese government has reacted by addressing issues around access to health care, fairness in market transactions and equality in educational provision. It will no doubt continue to target these areas as well as financial speculation—it has already taken moves against crypto-currencies.
In so doing, the Chinese do not act wildly or without forewarning. They do not have the same involved and public consultation process that the West has before they act—and they act. It is undeniable, as we have pointed out before, that pro-labor policy has been a headwind for profits and that regulatory initiatives may also cause extra burdens to be imposed on corporates. But the cry that China is against capitalism and is uninvestible is ignorant of the fact that China knows its great wealth creation is due to private enterprise. Its efforts to improve quality of life would be impossible without the capitalist. China recognized this for decades and formally ratified it at the Party Congress 20 years ago.
So, how does one invest in this environment? Well, be mindful of monopolistic profits and how you price them. Be mindful of speculative business models. Invest in those firms that create goods and services in China for Chinese to enjoy. Invest in those businesses that will increase health care access, produce the productivity enhancing capital goods, provide at a reasonable cost the retail services China’s middle class demands, and develop the financial architecture that supports long-term growth and wealth protection.
Years like this are always challenging to navigate. Partly, it is done by being prepared—balancing the secular and cyclical aspects of an investment portfolio. What one might lose in being less exposed to materials, one can gain by having a small-cap exposure. Partly, however, it is done by recognizing the long-term value that has emerged in some cyclical businesses—materials, manufacturing and banking. And a secular growth business may exhibit more cyclical behaviour if the economy in which it operates is by nature cyclical. But we do not follow around cyclical movements—rather we look for the long-term opportunities they may create. And we are not focused on the macro—rather we look to buy businesses we can hold for the long run.
Robert Horrocks, PhD
Chief Investment Officer