Fear and uncertainty in China?
It is commonly perceived that: China’s property sector is vulnerable; regulatory tightening of ‘new economy’ sectors has broken business models; and that the domestic economy will continue to slow. We only agree with the latter, and thankfully so does the Chinese government, with policymakers remaining committed to improving the quality, rather than quantity, of growth and reducing financial risk.
The strong rebound in China’s economy provided regulators with an opportunity to tackle animal spirits in the property and internet sectors. The extent of intervention surprised many, adding uncertainty to the mix as investors have had to gauge how far the reform drive will go, triggering a significant de-rating of share prices in affected areas. This has served as a reminder of the importance of understanding businesses prior to investing, with a focus on balance sheet strength a pre-requisite for those seeking to capitalise on volatility.
The philosophical challenge for investors is reconciling China’s anti-market behaviour with laudable goals such as ‘common prosperity’, reducing inequality and financial risk. The market tends to be binary in its opinion of China, as reflected in valuations, but despite negative headlines surrounding the casualties of policy tightening, peak uncertainty tends to be followed by easier conditions. Furthermore, while the business climate may remain challenging, there are still many very good businesses to consider for investment. After a difficult year, we believe that investment risk is now being far better rewarded, which is why we have been reducing our underweight position in China.
Leaning into risk
Our research efforts are directed towards contrarian ideas, where valuation anomalies naturally emerge. China has been an area of focus, but there are interesting companies operating in other emerging markets, which have struggled for attention in recent years. We find valuation levels to be undemanding given future growth prospects, and with no need to compromise on quality. Some of these companies have defensive business models, which would have traded on much higher valuations in the past.
As conditions gradually normalise, with travel restrictions lifted on the back of higher vaccination rates, we find scope for optimism towards re-opening plays in areas such as Thailand, Indonesia and Brazil. Consumption has generally been weak which contrasts with strong demand seen in developed markets, but we would caution extrapolating recent trends too far into the future.
Although the initial benefit of massive monetary and fiscal stimulus measures has been realised and is likely to remain a tailwind to economic activity for a while longer, a riskier point for markets lies ahead as governments in developed markets are forced to start charting a course back to policy orthodoxy. This contrasts with Asia’s conventional policy stance.
Finally, inflationary pressures are likely to remain a focus for investors. We feel that the best way to insure our portfolios against a more adverse inflation outcome is to avoid stocks whose current market valuations cannot be justified by their future cashflows even at current low interest rates. We believe that this is an environment that suits our investment approach, with a laser focus on valuation, seeking to find out where the market has failed to correctly price the multi speed nature of the recovery.
