Why Global Investors May Need More China Exposure
Chief Investment Officer Robert Horrocks, PhD, discusses how exposure to China's economic growth drivers can help enhance diversification for global investors who have often overlooked China's financial markets.
This year has made no sense in so many ways! Given all the economic disruption wrought by global lockdowns, few would have guessed that the markets would be up for the year. China is perhaps less surprising than other markets—for it dealt with the virus rapidly and effectively. China, has been solid with a rebound in the majority of macroeconomic metrics in what is now a predominantly domestic demand driven economy. In addition, China's equity markets look less vulnerable to valuation shocks because China's bond yields are back to where they were pre-COVID. One risk to Chinese equities would come from any loss of control over the virus—but that seems unlikely at this point. China's outlook has been further improved by the recent election in the U.S. of a less aggressive presidential candidate. This may be more of an issue of political environment, since the current administration, despite its rhetoric, seemed unable to severely hurt China's economy. Nevertheless, any improvement in international relations is helpful to investor sentiment.
Structural Changes Drive China's Growth
Over recent years, there have been significant structural reforms in China's capital markets and its economy, but perhaps almost unnoticed by many foreign investors who have been transfixed by the climb of the S&P 500 Index. First, China's domestic demand and services have become the economy's dominant driving force. This is partly responsible for the ineffectiveness of U.S. attempts to engage in a trade war. Secondly, access to China's markets—both equity and fixed income—has improved immeasurably over the last couple of years. This reform will likely continue at a fast pace as the authorities seek to improve the attractiveness of investing in China. Corporate governance reforms and other measures to increase returns on capital are desirable to maintain growth rates as high as possible for a country where the overall volume of investment as a percentage of GDP is in decline. Finally, we are seeing a big development in the markets in terms of the representation of innovative companies, including but not limited to the technology and health care sectors.
These changes mean that there has been a huge increase in opportunities in the Chinese markets—from traditional companies that are reforming their governance to businesses in new industries that are listing on the market.
For 2020, the greatest excitement by far has been around the latter category: entrepreneurial businesses that seek to offer new goods and services to a wealthier Chinese consumer. These businesses remain a key area of investments for us, not just for 2021 but in the years beyond. Telecommunications infrastructure, electric vehicles and batteries, sustainable power generation, e-commerce, health care services, medical devices, and even advanced oncology therapies—until comparatively recently, few of these businesses were available in sufficient numbers to be a significant part of portfolios.
COVID-19 lockdown, however, has also thrown up other opportunities. It has been a strange kind of recession—the contraction in supply and demand at the same time, and the burden of the lockdown falling on businesses that would normally have been seen as defensive, such as food, entertainment, retail and travel. Many of these businesses were hit very hard and given operating leverage, a quarter of lost revenues was enough to eliminate a year's worth of profit. However, the return to normality for some of these traditional high-street businesses and the comparative excitement around some of the virtual business models has generated a disparity in valuations that may, in some cases, be just too great.
Risks Remain But May Be Held In Check
COVID-19 remains a risk for economies globally, including China. While small pockets of coronavirus infections still occasionally emerge, China remains successful at flattening its curve of COVID-19. There is also a risk that some of the excitement around virtual businesses and some of the emerging industries may have been overdone or that the market is not accurately distinguishing between those emerging businesses that have a real chance of sustained success and those that are a passing fad or a flash in the pan. These are the risks of which the stock picker must remain wary. However, we believe there is much about the current economic climate that makes China look less risky than many other parts of the world. For the fact of the matter is that China and its people have shown greater discipline and awareness in how to deal with viral outbreaks.
The Case For Increasing China Allocations
Overall, I am encouraged that China, after a difficult year, will emerge looking fairly normal. We believe the reflationary environment that we expected going into 2020 but was derailed by the virus will re-emerge in China and the performance of the markets could broaden. In a reflationary market, returns tend to broaden. It is likely that we will see better performance from some of the small-cap businesses. Several small cap stocks have already done well this year, but predominantly in the technology and health care sectors. This may broaden out to more traditional industries. Also in a reflationary environment, value stocks have typically tended to perform well. This tendency can to some extent be ascribed to the preponderance in value stocks of materials companies and financials. Here, we remain cautious on the long-term prospects. However, even outside these sectors, we believe that a moderate reflation will tend to favor solid but slower-growing companies that have been overlooked and that the valuation differentials between growth and value stocks may narrow somewhat.
In a global context, the political environment internationally seems to be improving and China has done much internally to keep society relatively harmonious. While these are perhaps not issues that investors typically consider in forecasting returns, they have a direct impact on the balance between wages and profits and the ability of companies to grow earnings. When we look at relative valuations, we should be aware that the cause of social equity has been emphasized in China and many other parts of Asia but not in the U.S. and Europe. These facts make me more confident not only of the relative attractiveness of valuations, not just of the relative speed of earnings growth, but also that economic growth, profit growth, capital returns, and capital market developments may even be on a stronger underlying foundation in China for the next decade than they are in some of the world's other major economies. After having been largely ignored by or avoided by foreign investors for the past few years, there are signs that once again investors in the U.S. and Europe are looking at China as an intriguing prospect.
Robert Horrocks, PhD
Chief Investment Officer