Beijing clampdown could make investors reassess China exposure
During the final week of July, Chinese shares endured heavy selling with the CSI 300 index, the MSCI China Information Technology index and the Hang Seng Tech index plunging into negative territory for the year.
As a result, many popular open-ended China-focused funds such as Allianz China (BKFW2B5) which has €11.1 billion of assets and the $2.4 billion Fidelity China Focus (B51RX72) also saw their year-to-date returns turn negative.
The sell-off even spread to investment trusts, which don’t have the same liquidity issues as open-ended funds when investors rush to sell. Baillie Gifford China Growth (BGCG) hit a low of 408p, down 23% on the year, while Fidelity China Special Situations (FCSS) fell to 342p, down 10% on the year.
Unsurprisingly, investors will be asking themselves whether this is all a storm in a teacup and if they should therefore use the sell-off to average down, or whether the investment case for Chinese equities has fundamentally changed.
THE GREATER GOOD
The selling was caused by growing concern over the extent of Chinese state intervention in private sector businesses such as education, healthcare, property and technology.
For months the Chinese government has been waging war on private businesses which it claims are profiteering at the expense of the broader public. It wants everyone to have access to affordable education, healthcare and housing (the ‘Three Mountains’) in its drive for social equality.
It also wants to reduce what it sees as financial risk, and it is deeply unhappy about the vast private data sets built up by tech firms such as Alibaba, Didi Global and Tencent, which gives them insights into the behaviour of large swathes of the population.
For now, the government isn’t worried about the impact on the stock market, it is pursuing these firms ‘for the greater good’.
In education, the government says the private sector has been ‘hijacked by capital’. It wants companies that teach the school curriculum to go non-profit and has barred them from listing their shares on a stock market or seeking foreign capital.
Education firms whose shares are already listed on a stock market such as TAL Education and Gaotu Techedu, which have large amounts of data on Chinese citizens, could be forced to delist from foreign exchanges.
The government has said it will continue to allow Chinese companies in other sectors to float in the US. However, reports circulated last week that ride-hailing firm Didi Global, which only listed in the US in June, was considering delisting to placate the authorities.
$1 TRILLION WIPEOUT
Since their February peak, shares in Chinese technology and education stocks have lost more than $1 trillion in market value.
Overseas-listed Chinese shares have also been badly affected, with the Nasdaq ‘Golden Dragon’ index which tracks 98 of China’s biggest firms listed in the US dropping 15% in just two days, wiping $769 billion off its value.
The sell-off has extended to the bond and currency markets as fears spread that foreign investors were selling Hong Kong and Chinese assets across the board.
Impact on investment trusts
Numis says the effect of the current issues in China will not be uniform across Asia-focused investment trusts.
‘We understand that Dale Nicholls of Fidelity China Special Situations had been trimming technology and healthcare holdings on valuation grounds over the last 12 months in favour of industrials and materials,’ it says.
‘In addition, he reduced internet-related names in recent weeks reflecting increased focus on competition regulation. However, it is perhaps surprising to see Fidelity China had the largest exposure to the tech-giants in the peer group at June, given a more value driven approach.’
Numis adds that Baillie Gifford China Growth and JPMorgan China Growth & Income (JCGI) have more growth orientated strategies and therefore significant exposures to tech stocks would be expected.
‘We would expect Baillie Gifford to remain focused on long-term growth opportunities and it has typically been willing to ride out periods of market volatility or use them as buying opportunities for its favoured stocks.’
Numis says the managers of JPMorgan Asia Growth & Income (JAGI) note that the Chinese government tends to go through periodic phases of regulatory crackdowns and that this should be expected. ‘They acknowledge that the technology sector will be impacted but they have conviction in their underlying holdings and may use recent falls to add to existing holdings.’
Direct exposure to Chinese education stocks is relatively low among investment trusts, with typically less than 1% of the portfolio for the select few trusts which do have relevant positions.
The issue for investors is that it’s hard, if not impossible, to price in regulatory risk, which in turn raises the question of how to value Chinese stocks. Moreover, there is no way of knowing how much more aggressive the authorities could get with listed companies.
If foreign investors decide they need a higher risk-free rate before they think about buying Chinese stocks, there is a good chance the market will be in the doldrums for some time to come.
Simon Edelsten, manager of the Mid Wynd International (MWY) investment trust, sold all but one of his Chinese holdings earlier this year.
‘Beijing appears to be stamping down on entrepreneurs it sees as putting their own interests before those of the state, but that has enormous implications for overseas investors who hold shares in Chinese companies,’ he says.
While there may be a ‘dead cat bounce’ in stocks, investors ‘should be checking what exposure they have to China and asking how comfortable they are with what looks to us to be enhanced political risk,’ he adds.
Andrew Ness, manager of the Templeton Emerging Markets (TEM) investment trust, called the government action ‘a one-time reset of regulatory paramountcy, similar to previous cycles in China’s economic development’.
He doesn’t expect Beijing to take a broader approach, but he agrees that ‘investor assessments of policy risk will undoubtedly rise as a consequence of these actions.’
Dale Nicholls, manager of Fidelity China Special Situations, says while his investment trust has lowered its expectations for some stocks, many companies in the tech space are now trading at historical low valuations.
‘Investment is all about risk-reward and for many names, this is looking favourable after recent moves,’ he adds.
To compound matters, there are concerns the US could impose restrictions on investments by US companies in Chinese and Hong Kong stocks, while demanding greater disclosure for those Chinese companies co-listed in the US.
At the same time, there are fears China could increase its scrutiny of foreign companies which it believes have hijacked other sectors, not just in the technology and education industries.
Few people seem to have spotted that Tesla has just designated its Shanghai facility a ‘primary export hub’, which suggests Elon Musk has read the runes and opted to avoid a run-in with Beijing, even if it means no longer focusing on selling cars to the Chinese market.
TOO BIG TO FAIL?
The biggest sector in the Chinese economy is real estate. Technically, private individuals and companies are barred from owning land as it belongs to the state. However, since the 1980s local councils and municipalities have leased land to property firms for several decades in exchange for large upfront payments.
Evergrande Group is the biggest property company in China, with over 230 million square metres of land in over 230 cities. It is also the largest issuer of US dollar-denominated sub-prime debt in the world, with a balance sheet of more than $350 billion.
Its debt trades at less than 50c on the dollar, suggesting the company could default, after news broke that one Chinese bank had frozen some of its deposits and four more banks in Hong Kong had refused to grant mortgages on two of its apartment developments.
Next year, Evergrande must repay or roll over $7.4 billion of maturing bonds, the majority in US dollars. With the shares down 66% already this year, the firm has cancelled a planned special dividend to conserve cash.
The firm is thought to own around $80 billion in equity stakes in other, non-property related Chinese businesses, but as always equity is only worth what a buyer will pay. If Evergrande fails, it would send shock waves not just through the Chinese banking sector but through the global financial system.
THE APPEAL OF INCOME
For investors who want to keep some exposure to the Chinese market but would like some form of security, an income fund could be a good fall-back position.
The team at Aberdeen Asian Income Fund (AAIF), which yields 4% and is sitting at a 10% discount to net asset value, are sanguine about the recent sell-off. They say: ‘Despite the events of the past week, we believe the private sector retains a critical role in ensuring the Chinese economy continues to innovate and prosper.
‘Companies that can adapt to emerging regulatory frameworks and align with policy objectives such as digital innovation, green technology, access to affordable healthcare and improved livelihoods will continue to have a bright outlook.’
The investment trust has consistently avoided the large Chinese banks due to concerns over the reliability of dividends, and while it owns property stocks, its focus on companies with good visibility of revenues and solid balance sheets means ‘we do not, and never have, owned Evergrande,’ say the team.