investment insights
Chinese tech turmoil and equality distract from fundamentals
Lombard Odier Private Bank
Key takeaways
- Tech firm regulations and crackdowns have seen equity markets fall as China sets out oversight standards and data protection
- China’s ageing population will impact GDP, however the country’s productivity means it can still achieve its goal of doubling the economy by 2035
- Monetary and fiscal policies are more supportive, and the regulatory environment should shift focus to compliance within 6-12 months
- Short-term volatility means investors should stay reactive. China’s underlying strengths support investments in the world’s second-biggest economy.
China’s regulatory crackdown on technology firms continued last week, prompting another decline in the country’s biggest equity names. At the same time, the government reiterated calls for greater income equality, triggering declines in education stocks. The falls in Chinese share prices have prompted investors, including ourselves, to look closer at China’s prospects. Short-term volatility should not cloud China’s underlying investment strengths.
The crackdown is in part an attempt to put in place the data protection and anti-trust legislation that was, until now, weak compared with global peers, and brings China closer to international standards. Chinese regulators have strengthened anti-trust enforcement, including fines, warnings and investigations on acquisitions and joint ventures to counter monopolies. These rules have challenged firms such as Alibaba, Tencent, Baidu, Didi Global and Meituan. Chinese authorities have also set higher standards for Initial Public Offerings, including suspending Ant Group’s USD 37 billion listing in Hong Kong and Shanghai, which would have been the world’s biggest, as well as tightening online lending and banks’ capital requirements.
The Cyberspace Administration of China (CAC) has led changes to data security, restricting personal data collection after Weibo Corp.’s social media work to influence public opinion last year. In mid-July, the CAC also removed Didi Global, with almost 500 million ride-hailing customers, from Chinese app stores. Didi first listed shares on the NYSE on 30 June. Authorities now require firms with more than one million users wanting to list in a foreign market to go through a cybersecurity review. Separately, one of Tencent Holding’s computer games was criticised as “electronic drugs” by a state-owned media earlier this month. Shares in Tencent, China’s most valuable company, fell 11% taking its slide to 45% since a January 2021 high.
‘Prosperity for all’
Some of the regulation has been explained in terms of levelling incomes. The country’s Central Financial and Economic Affairs Commission said last week that it plans to “regulate excessively high incomes and encourage high-income groups and enterprises to return more to society”. In a further challenge to the tech industry last week, Chinese President Xi Jinping demanded “regulation of high incomes.” Rather than working to generate wealth at any cost, the party now aims at “common prosperity for all.”
China wants to become a high-income economy over the next 15 years by doubling gross domestic product. The World Bank defines a high-income economy as per capital gross national income of more than USD 12,535. In 2019, China’s GNI per head was USD 10,410, a ten-fold rise since the country joined the World Trade Organisation in 2001. The World Bank estimated in 2018 that 373 million Chinese citizens earned less than USD 5.50 per day, its poverty threshold in “upper middle-income countries”.
In a further indication of the Communist Party’s thinking, last month regulators also said after-school private tuition in core subjects must be not-for-profit, aiming to lower living costs and so increase China’s birth rate. In October 2015, China lifted its one-child policy after more than three decades, to two children per couple. That has not been enough to stop 2020 recording the country’s slowest population growth since the first reliable census of 1953, and the nation’s fertility rate has fallen to 1.3 children per woman, below both the US’ 1.7 and 1.4 in Japan. In May 2021, the Chinese government lifted the limit to three children.
China’s demographic challenges are mounting as its population ages and fewer workers must compensate for a lower taxable base. The nation’s ratio of working-age people to those over 65 years old has increased from 11% to 20% within one decade as the working-age population fell 3%.
While the United Nations has forecast that China’s population will peak in 2030, it is also possible that it has already reached its highest level. Even the People’s Bank of China (PBoC) has warned that there are incentives to over-state population data at the regional and ministerial levels, because population numbers are tied to budgets. “We must realise that China’s demographic picture has reversed,” the central bank said in April.
Growth outlook
China’s demographic ageing began to detract from headline growth in 2016 at the rate of 10-to-30 basis points per year. Over the next 15 years, we expect this process to cut an average of 50 basis points from growth, removing as much as 1 percent from GDP by 2035. However, if China successfully replicates the productivity paths of South Korea or Taiwan, it should be able to maintain annual growth of 4.0-to-4.5% despite its demographic pressures.
In March, the PBoC projected potential annualised growth of between 5% and 5.7% through 2025. We believe that China’s long-term potential growth is now below 5%. That said, next year, we expect the economy to grow 5.3%, suggesting that there should be no decline in employment, despite the negative demographic effects of an ageing population.
In the very near term, the economic impact of Covid’s Delta variant, a slowdown in credit and investment flows as well as recent regulatory changes will all undermine third-quarter growth. Nevertheless, the economy still enjoys fiscal and monetary support. We expect the last three months of 2021 to compensate for some of this quarter’s weakness, and forecast above-potential growth of 8.7% for this full year.
Adjusting equity allocations
For now, with Chinese regulation news driving the market, investors need to remain reactive. Nevertheless, we believe that the drive to deliver a new regulatory framework will slacken within six to 12 months as China moves into a compliance phase and companies adapt. In particular, those companies not already targeted will move to meet the rules in order to avoid more damaging attention. Nor do we expect this regulatory drive, filling a gap where there was little before, to take an even more dramatic turn towards nationalisation.
In March, we cut our exposure to Chinese equities to an underweight portfolio position, as we saw growing regulatory risks, tightening monetary policy and unfavourable momentum in earnings. That cautious positioning paid off. Now, equity valuations are closer to their averages and with the PBoC’s more accommodative monetary policy, we expect business activity to improve. As a result, we believe that markets will prove more stable and the risk-reward balance has already changed. We have therefore taken advantage of recent market price moves to bring our positioning back to neutral.
Chinese fixed income yields remain attractive and continue to offer portfolio diversification. The renminbi continues to benefit from solid valuations and a robust balance of payments, however exports have slowed and the central bank’s more neutral policy mean we have taken some profits on our exposure to the currency by halving our overweight allocation.
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