Chinese Shape Shifting: Rectangles Turning Into Circles?

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We published a piece last week suggesting that the valuations of some high-quality growth companies were now discounting investor concerns about the Chinese market. In otherwords, a lot of the bad stuff was “in the price” or pretty close to it. The piece provoked a lot of feedback.

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Although the piece dealt primarily with valuations a number of you wanted to know more about other topics which have led to the market being derated. Our views on these are summarised below.

Business Regulation

The South China Morning Post is today a particularly interesting publication. Published in Hong Kong, it is now owned by Alibaba, itself clearly under some scrutiny, yet no doubt keen to be seen to say the right thing. So, hardly free and objective paper. All that said, when it reports that China’s anti-trust chief, Gan Lin, has declared an early victory in getting rid of the once-widespread practice of “picking one out of two” merchants within the e-commerce sector”, we are encouraged. Gan goes on, “monopolistic behaviours by platforms and disorderly competition have lessened”. These are not the words of someone preparing for war, but more likely preparing the ground to rebuild, confirming our view that the worst is behind on this.

Another positive surprise came with the little reported validation of Variable Interest Entities or “VIEs”. As a reminder, VIEs use contracts to simulate equity ownership in Chinese businesses which are on the “Negative List” for foreign ownership, which includes the majority of internet businesses. The National Development and Reform Commission (NDRC) and the Ministry of Commerce first released a new version of the Negative List, clarifying the position in favour of VIEs. Then the CSRC clarified the requirements for listing VIEs overseas. All this has, for the first time ever, granted legitimacy to a structure that Alibaba, Tencent, Baidu, Meituan, JD and many others use to tap foreign investors.

The Property Sector

The only big concern we would have towards the Chinese property sector is that the public’s confidence in the value of bricks and mortar as an investment and store of value was to evaporate. While local sentiment toward property has weakened, unsurprisingly, it has not collapsed, with a rebound in residential sales in December confirming that the “buying the dips” attitude still prevails. This was no doubt helped by soothing words from the government and some relaxation of mortgage rules. Secondary pricing in most major cities has, in fact, been edging up since about October.

It is as well to remember however, that property is no longer the only game in town for Chinese savings. One of the fastest growing sectors in China at present is wealth management, and this is partly fuelled by the diversification of savings away from property towards equities and mutual funds, which the current concerns will likely accelerate. This is a trend which we see as inevitable and sustainable, and holding East Money is at the forefront of this.

What of the black hole of debt enveloping Evergrande and others? From an equity market perspective, we would argue that valuations now seem (belatedly) rational. The equity of the most troubled developers has already been marked down to virtually zero, or rather the value of an option on some form of restructuring, and while there may be a few more additional members to this sorry list, it is largely in the price for most. Fallout among the banks and other lenders is still ongoing, but, again, we wonder how much will now surprise the equity market.

The Economy

Lastly, what of the broader economy, is it not slowing down, heavily indebted, ageing rapidly....? Yes, yes, and yes... oh dear, it is looking more like Europe or Japan every day. But look a little deeper and things do not seem so bad. Exports are booming for a start. The statistics are horribly distorted by Trump’s 2018 tariffs, or rather the efforts of both Chinese exporters and US importers to avoid said tariffs, but there is little doubt that China’s share of global exports has reaccelerated. Covid helped with our need for PPE and extra electronic and gym equipment, but now it is more to do with solar panels, batteries and electric vehicles. All those things we need to save the planet and, like it or not, they are all going to come from China. China already has vastly superior scale in these areas, and increasingly the best technology as well.

While notionally overseas companies with most of their production in China are trying to diversify their supply chains, there seems little slowdown in foreign investment into China, albeit mostly now to serve the domestic consumer. Couple that with still positive equity and bond flows, even if lower than 2020’s blowout numbers, and it is not surprising that the Renminbi is stronger even than the mighty Dollar. China does not have an inflation problem and has very rare positive real interest rates. With many investors worried about the impact of rising global interest rates is as well to remember that China is the only major country that is easing. We see this as set to continue in 2022.

About the Author

Rob Brewis is one of the three fund managers responsible for the Aubrey Global Emerging Market strategy. An engineering graduate from Cambridge, Rob began his career in 1988 at Thornton Management in London before moving to Hong Kong in 1989. There he managed the Asian Special Situations Fund for Credit Lyonnais. Having been an early investor in a number of nascent Asian markets during the 1990s he also managed several single country funds investing in India, Pakistan, Indonesia and Thailand as these markets opened to foreign investment and grew in size. Rob co-founded an emerging markets investment boutique, BDT in 2000 before joining Aubrey in 2014.