Update on China stock market
While China has been leaning into antitrust regulations in recent months, the new regulations announced by China’s government over the weekend caught the markets by surprise, resulting in a broad-based selloff. Since the start of the week (ending 30 July), the Hang Seng China Enterprise Index (HSCEI) has declined by 10%, led by Technology, New Economy, and Education sectors. Month-to-date, China real estate stocks corrected 17% on negative news from several company specific issues.
China stocks fell sharply after the following events:
1. Regulations for the education sector which turned out to be much worse than market expectations include a ban on foreign capital investing in academic tutoring for K12, a ban on using a variable interest entity (VIE) structure, and a requirement for these companies to be non-profit entities. The impact is severe and has led to a mass exodus from this sector.
2. Regulators said they will aim to improve order in the property management sector.
3. Meituan (3690 HK) is under an antitrust investigation for its practices such as forced exclusivity arrangements with restaurants. On 26 July 2021, regulators also issued new guidelines calling for improved work standards for food delivery workers, including implementing local minimum wage and reducing workload intensity.
4. Didi (DIDI US), a ride hailing giant which went public last month, has been hit by data security concerns. This crackdown on Didi led to TikTok parent ByteDance to shelving its planned initial public offering.
Among China stocks, ADRs fared the worst. As at 27 July 2021, China American depository receipts (ADRs) and H-shares have plunged 40% and 28% respectively from their peak levels in February (Figure 1). The selloff was especially intense in the later part of July 2021. The HSCEI, which comprises 50 China enterprises listed on the Hong Kong Exchange, saw a massive sell down within days in reaction to the regulatory changes. At the same time, a large property developer in financial distress sent the sector into tailspin, further weighing down on market sentiment. These developments shocked the market, causing investors to take abrupt portfolio action.
Figure 1: China ADRs under pressure (YTD, rebased to 100)
Table 1 shows the list of worst performing stocks over the past five days, which include both new and traditional economy stocks. Notably, the education firms’ market values collapsed by around 70%, followed by health care platforms, ride hailing, and food delivery names, which corrected 28-30%.
Table 1: Performance of select China stocks over the past five market days
Against this backdrop, our conviction calls in China e-Commerce and large cap tech stocks were also sold down in sympathy.
Rationale behind recent government measures
China wishes to raise equality by narrowing the wealth and income gaps, provide an adequate baseline level of livelihood for its people, and promote its 3-child policy. Areas that it needs to address include housing, health care, education, and antitrust regulation against large companies that stifle competition and under compensate their staff. Lowering the cost of living and raising salaries will lead to higher disposable income and boost consumption in order to drive the economy. Creating a more levelled playing field to incubate the development of smaller companies to become future leaders will lead to greater success for the economy as a whole.
Semiconductor, clean energy, and domestic consumption sectors will be supported by the government. While certain sectors are facing headwinds, other sectors will be supported by the government. Companies which operate in these sectors stand to benefit from favourable policies. China is determined to raise its self-sufficiency in semiconductor manufacturing and wishes to achieve carbon neutrality by 2060 and peak emissions by 2030. In its 14th Five Year Plan, it stated targets for carbon emissions, increase in usage of non-fossil fuel energy sources, improvement in energy efficiency, and increase in the use of electric vehicles. China wishes to encourage domestic consumption to drive its economy.
High level of domestic confidence – Over the years, tertiary industries, predominantly the services sectors, have expanded their importance in the gross domestic product (GDP) composition to 54%, as at the end of 2020. A huge silver lining is that China’s consumer confidence has stayed at a multi-year high (Figure 2). This is crucial to the continual growth of the world’s second largest economy. A robust domestic economy will be paramount to the government’s long-term sustainable GDP growth target.
Recommendation – We remain constructive on China large cap Internet and e-Commerce firms with moat-like business operations, established ecosystems, and well-developed supply chains. Their fundamentals will continue to support the long-term outlook and recovery.
Market sentiment will likely remain weak for now in view of the regulatory implementations, as the new regulations could well put a lid on the business outlook of select new economy sectors. As such, we turn cautious on China ADRs.
Nonetheless, the long-term growth trajectory remains intact from China’s mammoth domestic economy, digital transformation, and the government’s commitment to develop the local technology supply chain.
Importantly, in CIO’s Barbell Strategy, we continue to emphasise investing in stocks with robust profit track records and compelling valuations, while avoiding companies that have yet to show profitability. As a result, we have not held any education, ride hailing, health care platforms, and speed delivery counters. We also stay invested in the large state-owned banks as a dividend play for the income generation end of our Barbell Strategy.
Given the rather sharp correction over such a short period of time, valuations have become even more attractive (Figure 3). The price-to-book ratio of the China Enterprise Index has entered the trough territory of below -1 standard deviation to historical mean.
Figure 2: Consumer confidence near multi-year high
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