By Martin Lau, managing director at FSSA Investment Managers, part of First Sentier Investors.
In an environment of rising inflation, tighter regulations, the risk of property bond defaults and concerns about an economic slowdown, does China still offer attractive long-term growth opportunities?
While inflation is a challenge globally, China’s more notable challenge is its zero-Covid policy, which poses a bigger challenge to corporate investment and consumption. For instance, there have been many cases where consumers placed online orders during the lockdown but could not get them delivered. Therefore, investors are keen to see if there will be any announcements regarding the relaxation of this policy during the upcoming 20th Party Congress.
Inflation in China is only 2-3%, which is much lower than in the UK and US, where inflation has reached 9-10%.
For companies, the increase in the Producer Price Index (PPI) is higher than the rise in the Consumer Price Index (CPI), and to overcome these challenges it is important for companies to be able to pass on their costs to customers. As a bottom-up investor, we prefer companies that can do this successfully.
The effect of tighter regulations
The ‘common prosperity’ agenda, which aims to reduce living costs and alleviate poverty, has driven higher regulatory standards. This can be seen in other countries too, although those implemented in various sectors in China – such as education, internet, medical and property – are relatively more stringent.
Share prices have already factored in these regulatory challenges, and in fact the regulations can help these industries improve. With increased regulatory scrutiny, companies might take a more disciplined approach instead of, for example, making unnecessary expenditures. And smaller, unprofitable companies may have to close, resulting in a healthier industry environment. Meituan, JD.com, Pinduoduo and Alibaba all improved their profits after regulations were imposed on the technology sector, as there was less competition around.
In the property sector, sales have dropped by 30-40% and prices are falling. But when a sector is in such bad shape and becomes under-invested, new growth opportunities may arise over the next 2-3 years. A sector in the trough of its cycle could offer attractive investment opportunities for the future.
What should investors look for in the current geopolitical environment?
I believe geopolitical risk is a mid-to-long-term factor and it makes, for example, mainland Chinese manufacturers’ businesses more complicated. Sino-US trade tensions are challenging to navigate as it causes supply chain disruption for mainland Chinese manufacturers. Labour shortages coupled with export tariffs to the US and Europe have encouraged companies to relocate their factories to Southeast Asia. However, some foreign clients may require manufacturers to base their operations close to them to minimise transportation or carbon emissions. Chinese companies that can produce their products globally, be it in Europe, Cambodia or Mexico, and have the ability to pass on their costs to their customers, will sharpen their competitive edge over the others in the long run.
Will depreciation of the renminbi (RMB) boost Chinese export companies?
Depreciation of the RMB does not necessarily translate into a boost to exports. There is some concern about the possibility of a US economic recession. It is important to identify manufacturers that can pass on their increased costs to clients and produce goods globally. Should we avoid consumption stocks because of a deprecation of the RMB? We believe China’s economy will continue to grow and the consumption upgrade trend is still intact – the rise of the middle classes will continue to drive consumption.
Over the past 10 years, we have noticed a trend of improved product quality in China and the emergence of domestic champions. For example, half of the electric vehicles are now Chinese-branded; household appliance manufacturers Haier and Midea have replaced Sony and Panasonic to become the biggest players in China; Anta Sports has become the second-largest sportswear maker; and Proya Cosmetics has grown from a small company to one of the most well-known cosmetics companies in China.
Like Japanese and Korean brands, Samsung and LG, in the past they were regarded as weak but are now widely accepted. As China’s sense of nationalism becomes stronger, Chinese people will have greater confidence in their own domestic brands, which in turn can drive up demand for domestically-branded products.
In the current environment, which sectors do you like?
We now see huge potential opportunities in manufacturing and medical equipment manufacturers, which are still relying heavily on imports. For instance, 70% of medical equipment in China is still imported. China’s largest medical equipment company, Shenzhen Mindray, is gaining market share from its foreign competitors. As companies invest more into research and development (R&D), in the long run we believe there could be a future Samsung, or a future Sony, from China.
What do you think about investment opportunities in Asia more broadly?
Apart from China, we believe India has good potential. IT services in India are well developed and there are high-quality banks such as ICICI and HDFC. Another interesting area is Southeast Asia, which has been ignored by investors who have tended to focus on China and India. In fact, valuations of companies in Southeast Asia are relatively low, offering good potential investment opportunities.
As more companies move their manufacturing bases to Vietnam, this will create new jobs, lift income levels and lead to increased consumption power. And Indonesia also has a competitive advantage with its rich resources.
Southeast Asia has a large and growing working population and rising domestic consumption, especially in the Philippines, Malaysia and Indonesia. The under-25-year-olds account for almost half the population and is still growing, which should translate into an economic engine for the region in the future.
