Addressing recent investor concerns on China
Fund Manager Q&A - September 2023
In response to the recent client interest around China’s stock market and the challenging performance year-to-date, we had a conversation with Martin Lau, managing partner and lead portfolio manager to a number of Asia Pacific and Greater China equity strategies. The discussion took place on 23 August 2023.
Do you expect the Country Garden default will have spill-over effects to other industries and lead to systemic risks? What risks and opportunities do you see from this incident?
Rather than focusing on this particular case with Country Garden, we think the market is more concerned about the growing number of defaults in the property sector, like we saw with Evergrande, Sunac and Shimao in the past two years. Property is a key engine for China’s economy, so we expect the ongoing weakness will have a negative impact. It has implications for other areas such as banks, construction, home appliances and building materials. It also affects personal wealth and consumer demand. However, we don’t think there will be systemic risk, like Lehman Brothers in 2008 which had a domino effect.
There are a few reasons for this. In China, nearly all the banks are owned by the government. If they choose to roll over their debt to a company, that can stop the company from failing. That is, unless the government wants something to fail. When Lehman went bankrupt, the market was wondering where the next Lehman will be. Like a self-fulfilling prophecy, this made banks scared to lend and led to a global financial crisis. We think this is not likely to happen in China today, due to the high levels of government control and ownership.
Another reason is that there is very little foreign debt in China. The 1997 Asian Financial Crisis started in Thailand and spread to several other countries, due to its large holdings of foreign debt. In China, most of the debt is in renminbi (monetary unit of China), so it’s less likely to trigger a global contagion. More than half of the private property companies with large US dollar debt have already defaulted.
To some extent we believe the Chinese government wanted this to happen because previously defaults were so rare, which led to some moral hazard* and excessive borrowing. The government is now focusing on quality growth and moving away from the old model which relied heavily on property and debt. We expect it will take some time to adjust and muddle through.
To date, our preference for quality and being conservative has helped to preserve capital. We have never invested in companies like Country Garden, Evergrande and Shimao, because we thought they were too aggressive.
Domestic demand is considered a key driver for economic growth in China. However we see unemployment remains high and consumer confidence is turning more pessimistic. Do you see any new opportunities arising from the change in demographics?
Companies are telling us that growth has slowed across the board, and this is true for consumer demand as well. But we think the longer-term trend around consumer upgrading is intact, and this remains a key structural driver in our portfolios. Some of our China holdings (such as China Mengniu Dairy, China Resources Beer (CRB) and Midea) have not changed and we still have conviction in them. These companies have the markers of quality that we look for, like strong financials, steady growth compared to peers, cashflow generation, and premiumisation.
When most investors are negative on China then perhaps it’s time to buy more. We believe that in the long run, share prices follow earnings growth. For example, CRB achieved around 4 to 5% growth for both volume and selling prices during the first half this year. Its premium products grew faster, with nearly 60% increase in the volume of Heineken beer.
These are a few examples of benefiting from sector consolidation and premiumisation. Hopefully the companies we invest in will continue to grow their earnings over the long term.
New loans fell and credit growth weakened in the third quarter. Do you think this will impact the growth and earnings outlook of Chinese enterprises? Will it impact China’s R&D expenditure and progress in moving up the value chain?
We think weak credit growth is a concurrent indicator which reflects a weak economy, rather than a driver or leading indicator. When confidence is weak, people are not buying houses but paying down their existing mortgages, and banks are hesitant to lend as large developers are defaulting. In the past five years, more lending was needed to generate each unit of Gross Domestic Product (GDP) growth. This likely caused concern for the government by showing the limits of credit driving the economy.
Meanwhile investors are concerned today because they are also seeing the limits to what the Chinese government can do, or is willing to do. The economy has high levels of debt in the system and many companies are experiencing problems. Against this backdrop, China is likely to slowly deleverage over time, so loan growth may stay weak and near-term earnings growth for companies would also be impacted.
Companies will probably cut back on research and development (R&D) as revenue slows down. Often it’s more about incremental improvements to existing products or processes, rather than having the most cutting-edge technologies.
We also favour companies which can expand overseas because it’s another sign of moving up the value chain. We believe when the domestic economy is weak, a good company can find growth in other markets. We saw this in Japan, with companies like Fast Retailing (Uniqlo), Toyota, Sony and Nintendo.
There are some parallels between Japan’s experience and China going forward, like the ageing population and slowing economy. But one difference is that it’s much harder to go global today vs. 30 years ago. Geopolitical headwinds are stronger today, like how the US put a halt to Huawei’s global expansion. But China is running out of labour, so regardless of geopolitics it needs to move production outside.
References:
1. Background on recent China defaults:
2. Most Chinese bonds are denominated in RMB:
https://www.morningstar.co.uk/uk/news/217180/chinas-bond-market-a-quick-primer.aspx
(as at 29 November 2021)
3. Default rate of Chinese real estate USD bonds has risen to over 50%:
(as at 28 July 2023)
4. China’s economy is highly leveraged:
5. Effects of anticorruption crackdown on China’s economy in the past:
https://www.bbc.com/news/blogs-china-blog-26864134
6. US bans Huawei equipment:
*Moral hazard refers to a situation where people do not care about the risk of something negative happening because they are protected from bearing the full cost of the negative event (for example, if they were insured against loss or damage).
Source: Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at 23 August 2023 or otherwise noted.
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