Opportunities amid China’s changing regulatory landscape

Michelle Qi September 07, 2021 06:00

The regulatory crackdown on China’s online education sector in August has triggered concerns that other industries could also come under the government’s radar. This has caused a sell-off in Chinese equities as investors reassess the risk premium associated with investing in China. Understanding China’s macro policy cycles has always been key to investing in the Chinese equity market.

Navigating the changing regulatory landscape

Lessons from the past show that the Chinese government tends to encourage new and emerging sectors and tightens regulations when the associated risks grow.

While the new regulations on China’s online education sector have been harsher than expected, the policy direction was no surprise. The Chinese government had over the past few years actively promoted the “equality of education” and imposed multiple restrictions on private schools. Changes to the sector therefore have been a long time coming.

For the internet sector, business models and regulations would need to adjust as the sector matures and data security becomes increasingly important. As China’s economy grows and evolves, tighter regulatory curbs can be expected on sectors which have been allowed to enjoy exponential growth in the past.

More than ever, experience, on the ground presence and active management will be needed to navigate China’s changing regulatory landscape. Investors would also need to distinguish policy messages from the noise coming from think tanks and other China observers.

We believe that there are still attractive opportunities even within sectors which may have been affected by negative investor sentiment. For example, we look to benefit from China’s rising urbanisation rate by investing in property management and pre-fabrication companies instead of property developers. Meanwhile, although tighter regulations may affect pharmaceutical companies or manufacturers of healthcare equipment, there are opportunities within the medical aesthetics service sector.

The intent behind the increased regulatory oversight on the pharmaceutical companies and healthcare equipment manufacturers is similar to that of the education sector - a desire by the Chinese government to reduce cost pressures on the households, and to enhance social welfare and equality.
The tighter regulations on the medical aesthetics sector on the other hand, focuses more on regulating industry competition and improving consumer safety. While regulation can affect the competitive landscape, it is unlikely to stop China’s consumption upgrade trend, in our view.

Why China A

As China’s headline GDP growth declined over the last two decades, China’s pace of reforms has picked up, which should result in more sustainable, higher quality and equitable growth. China’s growth engine has shifted from investment to consumption. With consumption accounting for only 56% of China’s GDP, versus 82% in the US and 75% in Japan, the upside potential to the economy is tremendous. Reducing China’s income inequality will help to lift overall consumption.

Given these structural changes, the government has proactively sought to encourage new growth sectors while trying to contain overall leverage and potential systemic risks post the Global Financial Crisis. The government has also increasingly realised the importance of environmental protection and have tightened emission requirements as well as implemented energy consumption quotas for various sub-sectors within the materials sector. These regulatory changes, together with slowing economic growth, have weighed on the property and banking sectors, what we refer to as “old economy” sectors.

As China’s economic growth model evolved over the years, new economy sectors which include commercial and professional services, insurance, software and services as well as independent power and renewable electricity producers, have outperformed. In fact, the top 100 most widely held A-share companies by foreign investors, comprising mostly of consumption, healthcare, technology, and advanced manufacturing stocks have risen 219% since 2016 on the back of strong earnings growth and a re-rating.

While there are multiple ways to gain exposure to these new economy sectors, the China A-share market offers investors higher exposure to the consumption, healthcare and manufacturing sectors. These sectors are aligned to the government’s national objectives and have received significant policy support – a development that may have been overshadowed by the recent regulatory concerns in the education and internet sectors. Meanwhile, the China A-share market has a lower exposure to the financials and real estate sectors. The China A-share market also has significantly less exposure (<0.1%) to the online education and internet-related sectors compared to the H-share (30%) and US ADR (45%) markets.

Why China A now?

Global investors are currently underweight China by over 4% in their global and regional fund allocations, almost the largest underweight on record. The 2022 estimated forward valuations for the China A-share market appear highly compelling especially against the US market. Meanwhile the China A-share market trades at a slight premium, on a price-to-earnings ratio, to the MSCI Global Emerging Markets ex China Index .

We expect credit and liquidity conditions in China to become more accommodative in the second half of 2021 as the government responds to slowing growth amid rising infections from the delta variant of the COVID-19 virus. Policymakers may also consider easing in order to offset the tightening credit conditions caused by the recent volatility linked to Evergrande and Huarong Asset Management. Historically, domestic policy easing has been favourable for the China A-share market.

While investors may have shied away from China stocks on the Hong Kong and US stock exchanges, the China A-share market has enjoyed robust inflows. With foreign ownership of China A-shares currently only standing at 4.5%, the potential for outperformance over the medium to long term is significant.

The Chinese government’s policy setting is guided by its core mission of stabilising growth, containing risks, encouraging equality and equity. The new economy sectors in the A-share market have significantly outperformed the overall market, reflecting the fundamental and policy changes in China. Understanding the government’s intent will provide a key source of alpha for investors.

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Michelle Qi

Head of Equity, Eastspring Investments, China