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T. Rowe Price: Circumventing China an error as clouds begin to clear

By Wenli Zheng, portfolio manager of the T. Rowe Price China Evolution Equity Fund

Chinese equity markets have endured a tough year. A confluence of factors has weighed on the market – including regulatory crackdowns, geopolitical tensions, the potential delisting of Chinese ADRs, an ongoing property sector downturn, and an outbreak of the highly contagious omicron variant of Covid-19.

Some investors have even questioned the logic of investing in Chinese equities. However, we remain constructive, as we believe there are both cyclical and structural reasons why Chinese equities remain attractive for investors.

Firstly, it is important to not focus solely on specific GDP growth figures but instead on where China stands in its economic cycle. We believe the economy is currently passing through its trough and should begin to improve over the coming quarters. The drag from Covid‑19 outbreaks and a weak property market are likely to alleviate. At the same time, we should start to see supportive polices come through that could help the real economy.

In addition, we have already started to see a more positive tone on the regulatory front, but the market remains muted due to a combination of previous concerns and negative headlines in a market that is currently very fragile. Some Chinese stocks are trading at one to two standard deviations below their Western peers. History suggests these types of dislocations tend to provide longer‑term opportunities.

Patience required as situation normalises

The dynamism, size, and depth of Chinese stock markets continue to excite us, and this rapidly expanding opportunity set offers real opportunity for long‑term fundamental investors to deliver alpha. For example, high‑end manufacturing is an area where we find ample opportunities.

While many companies are well positioned with strong competitive advantages, the near‑term outlook has been clouded. First by rising input costs driven by the Russia‑Ukraine conflict, then by supply chain disruptions from renewed pandemic lockdowns. Neither event alters our longer‑term views on those businesses. Rather, we believe the recent correction enhances the outlook for future returns.

The pandemic will remain a headwind for the economy, but we also see it as a catalyst for accelerating industry consolidation. We have seen meaningful capacity reduction in sectors like hotels, restaurants, and furniture retail. Industry leaders are widening the advantage gap versus smaller players. As the situation normalises, we could potentially see a stronger pricing cycle over the next couple of years with rising margins. It will require patience, but ultimately, we believe that we will potentially be rewarded with better returns.

Long term, we believe technology and innovation will continue to drive opportunities. Over the past decade, smartphone and mobile internet have been major sources of value creation. For the next five to 10 years, we believe electric vehicles (EVs) and the transition to greener energy will be the main drivers.

Ample opportunities as the world goes green

Globally, the auto industry is around eight times larger than smartphones. As opposed to cars powered by internal combustion engines (ICEs), where Chinese brands are viewed as offering inferior quality and technology, the picture is much better for Chinese manufactured EVs. While local manufacturers have a 30% share of the domestic ICE auto market, the share jumps to 65% for EVs.

China clearly has the potential to become a major global manufacturing base for EV autos and components. The investment opportunity is not just in obvious areas like electric car batteries and auto OEMs, but also in upstream areas like auto parts, automation companies, and semiconductors. We think EVs could become a critical driver for China’s industrial upgrade over the next decade.

China remains the world’s largest fossil fuel emitter, but we believe there is a real commitment to a green transition, and we have already seen policy shifting in this direction. The country is a significant importer of traditional energy today – importing 73% of its oil and 42% of its gas needs. Greater use of renewable sources of energy will allow China to become more self‑sufficient and serve both economic and social goals – helping to reduce the damaging effects of pollution on society.

The transition away from a carbon‑intensive economy to a more sustainable economy also offers a tailwind to industrial transformation. It is forecast China plans to spend in the region of $16trn on its green transition to achieve its goal of carbon neutrality by 2060. It also aims to achieve a peak in its emissions by 2030. We believe it is well placed to meet those targets. China already enjoys a 79% share of the global market for solar power and a 41% share in wind power. As more countries focus on renewable energy sources, China has the potential to gain from the green transition both at home and abroad.

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