2021 was a difficult year for Chinese equities, but we believe many of the headwinds that challenged these stocks last year will turn into tailwinds in 2022, underlined by recent news from the Chinese government that said it would “actively release policies favorable to markets.”1 We continue to be overweight China in our portfolios as we have been able to find more high-quality investments at attractive valuations, in our view, than in other parts of the globe. We also think current valuations reflect a worst-case scenario. With the government indicating it will continue to take steps to support both the economy and equity markets and meet its announced 2022 growth targets, we think there will be much improved environment for Chinese stocks moving forward.
Taking a longer-term view of China
Last year, we saw a broad-scale, indiscriminate sell-off in Chinese stocks driven by investor concerns about continued government regulatory actions of private companies, potential delisting of ADRs, ongoing COVID impacts to the economy, volatility in the real estate market, power grid failures, and more. Many investors exited China altogether, deeming it uninvestable. This drove valuations to become incredibly inexpensive even by historical levels.
While short-term concerns persist around the impact of COVID on the economy and potential involvement with Russia, our team continues to believe in the long-term opportunity in China. It’s the world’s second-largest economy,2 it maintains a long runway for potential growth, and it has an expanding middle class that is projected to support the economy with consumption. Many investors have been eager to see signs that Chinese equities will begin moving in a positive direction
One recent, strong signal came out directly from the Chinese government, announcing it would “actively release policies favorable to markets.” Importantly, the government also stated that it planned to ease up on the type of regulatory announcements that were a primary driver for the sell-off in Chinese equities over the past year, notably surrounding technology companies, increasing investor confidence that the government will seek to prioritize the impact on equity markets in its actions moving forward. Additionally, there were signs that additional governmental support measures may be coming, including lowered reserve requirements and other actions that should make it easier to obtain business and real estate loans. The collection of positive signals prompted a meaningful bounce in Chinese equities, including for real estate and technology companies that have been among the hardest hit over the past year.
We believe headwinds are manageable
Despite these positive developments and short-term rally, there have been other potential headwinds in the markets that have been giving investors pause that Chinese equities could continue a positive trend. However, in each case we think there are reasons for optimism that they are manageable:
- Russia. There has been growing concern that China’s alignment with Russia may lead to isolation from the global economy over time, especially with reports of Russia asking for military and economic assistance. It’s our view that China is ultimately going to do what’s in its own interest, and we think the government’s overriding near-term goal is to achieve its announced 5.5% growth target this year.3 Assisting Russia in the current Ukraine conflict to the degree of falling afoul of the US and the West and forcing a response would be extremely counterproductive, in our view.
- Delisting ADRs. Investors have been concerned about the recent news that the SEC published a provisional list of ADRs that could be subject to delisting, based on the 2020 Holding Foreign Companies Accountable Act (HFCAA). We believe this attention-grabbing headline represented an action that was only a formality and contains no new developments, as it was simply an initial list that, as per SEC rules, is expected to grow as ADRs issue their annual reports for 2021 in coming months. At the current stage, this is more of a matter between China and US regulators to determine if there are any potential solutions to avoid eventual delisting, and in fact, the Chinese government has recently given positive signals there has been progress. Even should delistings ever move forward, the process would be expected to be orderly and occur over an extended period of time, with investors expected to maintain access to Chinese equities through Hong Kong. We think this investor concern headwind is likely to moderate going forward.
- COVID cases. Another important issue has been growing evidence that the Omicron variant has been driving a renewed COVID outbreak in China. Given China’s historical zero-tolerance policy, investors have been fearing negative impacts on the economy, spending, and supply chain issues. We think the short-term impacts are not yet clear, and that the risks for equity markets must be considered alongside more positive signals like recent reports showing encouraging Chinese economic data in early 2022 and increasing signs the government is easing its stance on strict COVID countermeasures in order to better manage negative economic impacts. The government still has additional support levers to pull, having already initiated meaningful fiscal and monetary measures with an expectation for more to come.
Potential impacts from the Ukraine-Russian conflict hovering over global markets as well as the amount of noise muddying the picture for Chinese equities make it difficult to project near-term price movements. However, we remain confident about the long-term opportunity for Chinese equities. As bottom-up investors, we think it remains an excellent market in which to find high-quality businesses, with current valuations inexpensive on both a recent and historical basis. And, we are optimistic that the balance of factors that acted as significant headwinds over the past year will continue shifting in a more supportive direction.
1 Source: South China Morning Post, “Chinese Vice-Premier Liu He vows support for economic growth, capital markets amid mounting headwinds,” March 16, 2022
2 Source: International Monetary Fund
3 Source: Bloomberg News, “China signals more policy support with 5.5% growth target,” March 5, 2022