The China dilemma

Big Tech is finally in for a reckoning, but not where we might have expected. Having already put the brakes on Ant Group's initial public offering (IPO) following critical comments from Alibaba (HK:9988) boss Jack Ma last year, Chinese authorities have dealt investors another rude awakening via a series of regulatory measures. From sanctions on leading internet stocks to a ban on private tutoring businesses making a profit and a planned break-up of Ant super-app Alipay, regulation has hit all manner of sectors. This, and the escalating crisis at property developer Evergrande that has spilled out into global markets, sits in sharp contrast to 2020, when Chinese stocks powered ahead.

Recent peaks and troughs have been remarkable: Hong Kong’s Hang Seng entered a bear market in late August, dropping by a fifth versus its last high in February 2021, while other indices and China funds also suffered (see chart below). Yet Chinese companies, including the country's internet giants, posted a strong rebound as the month drew to a close. Some contrarian investors had already scented bargains: in July global value fund manager Hugh Sergeant made the bold assertion that Baidu (HK:9888) might be “the cheapest megacap I’ve ever seen in my career”.

Such names are still seen as world-leading companies, and any pause in the Chinese economy is unlikely to last forever. But is this a straightforward buying opportunity, or a warning? China has seemingly moved closer to the financial mainstream in recent years, but others see this year’s disruption as a reminder that it remains difficult, unpredictable and perhaps even uninvestable.

To the mainstream and back

As the well-known saying about sneezes and colds suggests, investors have long viewed the Chinese economy as important to global growth. But the Chinese market itself has also grown in stature, even if this has admittedly come in dribs and drabs.

The rise of names such as Alibaba has demonstrated that the country can foster businesses to rival anything out of Silicon Valley. Economic developments also help: the BlackRock Investment Institute used its recent mid-year outlook to break out Chinese assets from emerging markets as a region for asset allocation, citing both its growing importance and a fiscal tightening as portents to higher quality economic growth in future. “Chinese assets play a key role in our strategic views in an increasingly bifurcated US-China world,” the group noted.

In this context, recent events deal quite the blow – as much in paper losses as in symbolism. Take the cybersecurity review the Chinese government opened into ride-hailing business Didi (US:DIDI), a mere two days after its IPO, and the order for the company to remove numerous apps from its platform, something that helped sink shares by 30 per cent. Or the surprise crackdown on private tutoring which, in the words of Janus Henderson portfolio manager Mike Kerley, "triggered a global sell-offof nearly $1tn", wiping more than 50 per cent from Tal Education (US:TAL) and New Oriental Education and Technology (HK:9901) in the process.

Other moves, from limiting the time children can spend online gaming to a new data protection law and mooted restrictions on Chinese companies listing in the US, have hurt internet names such as Tencent (HK:0700), Alibaba and Baidu. Others also struggled: if Tencent is affected by the online gaming rules, so are the likes of NetEase (HK:9999) and Nexon Co (Jap:3659). Elsewhere, Meituan (US:MPNGY), the food delivery business, has seen its shares falter amid pressure to better treat employees and customers.

Such steep falls suggest investors accustomed to the idea of China as an established market have been caught unawares. As the investment team at Ruffer puts it, Beijing’s regulatory crackdown has offered foreign investors a “re-education in political risk”. Kerley goes further. “People have got carried away in the last five, 10, 15 years, thinking China is the same as everywhere else in investment,” he says.

Here lies a dilemma. China's economy is only growing more important. But the equity market itself remains divisive: investors who want to tap into the country's growth must accept that it remains an emerging market, with all the unpredictability, volatility and government tinkering that brings. As Somerset Capital's Mark Williams recently told our podcast, the regulatory onslaught struck him as "nothing new" in the context of China and emerging markets.

While investors have spent years fretting about the risks associated with state-owned enterprises (SOEs), it turns out private names – including a number of market darlings – are not immune to government action. And if intervention is not new, this episode stands out for the government's willingness to disrupt foreign investors. That is reflected in scrutiny of variable interest entities (VIEs). Used in strategically important sectors where rules limit foreign ownership, these shell companies allowed those outside China to get behind exciting names in the region. But vitally, they do not grant real ownership, one reason well-known stockpickers such as Terry Smith exclude China from their global equity funds.

What the crackdown means

The regulatory clampdown relates to the Chinese Communist Party's latest five-year plan and its broader aims. In August, Schroders fund manager Robin Parbrook outlined several aims behind the government action: national security, financial stability, social stability and mobility, and to advance a "dual circulation" strategy outlined in the latest five-year plan, emphasising self-resilience in critical sectors such as batteries, artificial intelligence and biotech. While the latter desire may be self-explanatory, Parbrook notes that greater scrutiny on companies with a primary listing overseas relates to national security and concerns about the volume of data available to US-listed companies, particularly as the US beefs up its disclosure rules. Financial stability relates to state concerns about tech companies creating excessive consumer debt.

The theme of social stability and mobility, meanwhile, relates in part to a commitment to “common prosperity” in the latest five-year plan and can be seen in various bouts of regulation, from a desire to improve Meituan driver pay to a hope that restricting online gaming may boost the chance of children exercising.

As Matthews Asia chief investment officer Robert Horrocks puts it, social issues have come to the fore of late. “People think of quality of life, a cleaner environment, access to healthcare, how people are educated, innovation in different industries, the ability to enjoy leisure, travel, video games and how to have a proper balance with those things and be productive,” he says.

With the government getting proactive, activities perceived as harmful or exploitative could be due a shake-up. This ranges from access to education to financial speculation in areas such as property. Healthcare has also come into the government’s sights, with measures focused on the pricing of medical goods and services.

In certain cases, bargain hunters may argue that recent share price falls overstate the impact of new rules. The Janus Henderson team, for one, has argued that a 20 per cent share price fall for NetEase, one of its holdings, seemed excessive on the back of online gaming restrictions for the young, given that just 2 per cent of the company’s revenues stem from purchases by the under 18s.

“Nothing has changed the long-term story [for those names],” Kerley adds of the internet giants. “China leads the way on payment systems and ecommerce. That trend will continue and these companies will continue to grow, but not at the expense of competitors or the general public. Are they a good investment? Probably they are at these prices, but in the short term it will be a struggle.”

Yet Kerley also believes it makes sense to “invest alongside the government rather than against [it]”. The authorities tend to stick to the five-year plan, with the latest iteration spelling out risks for those investing in sectors with high profit margins that affect individuals' cost of living.

Certain subsectors could be more resilient than others. Kerley suggests cybersecurity stocks (including Venustech (CHIN:002439), a holding) and cloud storage names look like decent bets. Key sectors that could benefit from investment as part of the dual circulation approach explained above may include batteries, electric vehicles, the internet of things, artificial intelligence and biotech.

Of course, there is also a bear case for those "bargain" internet stocks. “It appears the large internet stocks will have a lower return on invested capital following the regulatory changes," wrote Parbrook this summer. "This is likely to be the result of higher salaries for workers (Meituan), lower fintech revenues (Alibaba, Tencent), restrictions on gaming (Tencent, NetEase), measures to aid physical retailers (all ecommerce), removal of tax inventives (whole sector) and…. directed investment into key sectors that are considered a priority."

It should also be remembered that China troubles go beyond regulation. Following significant fiscal stimulus, the government has been looking to pull back spending this year. That, in the shorter term, can be painful, as can ongoing Covid measures, and the economy has already showed some signs of slowing. The country's Manufacturing Purchasing Managers Index dropped to a level of 50.1 in August while the seasonally adjusted Services PMI plummeted to 45.2, suggesting a contraction of activity.

Yet changes may be for the good. BlackRock believes an easing of stimulus might set the path for “higher quality” economic growth in future. "China is pursuing a more orthodox policy, partly to reduce risks in the financial system but also to make itself a more attractive investment destination. So far it’s working," the group's investment institute noted, pointing to a focus on stabilising debt levels in the wake of the pandemic – a move that would put China at odds with many other nations.

Accessing China

Pressure on VIEs and an inherent tension between US disclosure requirements and Beijing's concerns about the sharing of sensitive data make it more likely that Chinese companies will view Hong Kong, rather than America, as a natural capital market home. This, and the risks inherent in owning individual stocks in an unpredictable market, make it easier to access China via funds than the stocks that they can buy directly.

The dedicated China investment trusts, Baillie Gifford China Growth Trust (BGCG), Fidelity China Special Situations (FCSS) and JPMorgan China Growth & Income (JCGI), have unsurprisingly seen the value of their shares versus portfolio net asset value (NAV) fluctuate in recent months, with cheaper entry points emerging.

For a sense of how they were recently exposed, the third chart shows sector allocations in these three funds and in the MSCI China index. Note that sector definitions might seem misleading: Tencent is classed as a communication services stock rather than a technology company, with Alibaba classed as a consumer discretionary name. All three trusts had big exposures to those two companies, albeit less than MSCI China, where they made up a quarter of the index at the end of July.

As the chart below shows, when it comes to MSCI China's biggest sectors the trusts tended to be overweight communication services, healthcare, information technology and industrials, but underweight financials versus the index. For a better understanding of the portfolios it is worth checking investment manager commentaries, which tend to be common at points of market volatility.

While a single-country index such as MSCI China is clearly highly concentrated, a similar problem has long applied to Asian and emerging market funds. China made up nearly 40 per cent of the MSCI AC Asia ex Japan index and just under 35 per cent of the MSCI Emerging Markets index at the end of July. Tencent and Alibaba made up around a tenth of each index.

That means passive funds in the region have also been exposed to the Chinese volatility of late, as shown in our first chart. The fact that active managers often tend not to risk deviating too much from the biggest parts of their benchmarks means that many Asia and emerging market stockpickers will be similarly exposed. That said, a handful of names, such as Stewart Investors Asia Pacific Leaders Sustainability (IE00BKDRZ794), are known to have very little in China. On the passive front, Lyxor MSCI Emerging Markets ex China UCITS ETF (EMXC) offers one way around the problem for China sceptics.

When it comes to global equity funds, the China issue can be divisive. Terry Smith has expressed doubts, as did Blue Whale Growth (IE00BJM0BB81) manager Stephen Yiu in a recent podcast with Investors’ Chronicle. While the Scottish Mortgage team has long seen China as the home of innovative companies, the table below shows that many bigger global funds run by other firms have tended to steer clear. The same applies to passive funds: MSCI's World All Country index and the FTSE All-World each have around 4 per cent in China, giving it a similar allocation to the UK. When it comes to popular passive ranges Vanguard's LifeStrategy range does make use of emerging market and Asia funds, but even in the highest-risk fund both regions represent just 10 per cent of assets.

Indirect means: is Unilever an emerging market stock?

Of course, access to China’s growing wealth and other emerging market growth doesn’t need to come directly. Many stocks listed in developed markets have an international focus that extends to Asia, from strong sales of handbags to the rich in China by LVMH (FR:LVMH) to the boost emerging markets have delivered to Unilever (ULVR).

Plenty of funds have a good level of direct revenue exposure to China without investing directly. When it comes to open-ended funds investing for growth in Europe and the UK, Morningstar data states that UK value fund M&G Recovery (GB00BK7XXV30) recently derived 15 per cent of its revenue exposure from China, with FTSE 100 trackers clocking a similar amount. In Europe, BlackRock Continental European (GB00B4VY9893) and Schroder European (GB00B68H8S84) each had an exposure approaching 10.5 per cent.

Global funds, with their international remit and a mandate to hold Chinese stocks if the investment team wishes, rate much higher by this metric. The Baillie Gifford Long Term Global Growth Investment fund (GB00BD5Z1187), a name that appears to have overlap with Scottish Mortgage, had nearly a third of its revenue exposure to China. It should be noted the Morningstar data is not comprehensive, and may miss some exposed names.

Generally, big backers of large, internationally-minded stocks, from many global funds to portfolios of UK large-cap stocks, are likely to have more indirect China exposure. Kerley notes, for example, that retail giants Nike (US:NKE) and H&M (SWED:HM-B) this year faced a backlash from Chinese consumers after expressing concern about the alleged use of Uighur forced labour in the production of cotton. With a loyalist Chinese consumer, international spats can also hurt sales for foreign companies, whether via government action or what people in the world's second-biggest economy might shun. This means that even taking indirect exposure can come with drawbacks.

"These spats can have an impact on how you invest, especially if you go for international companies as a way to buy China," he says.