Regulators are rattling investors in China. What's next?

The investment world has reacted with horror to the idea that Chinese communist policy makers and regulators might not be enthusiastic about large private companies with too much pricing power.

The regulatory clampdown on online education platforms and tech giants such as Tencent and Alibaba has had an inevitable knock-on impact on the price of the leading UK-listed China funds.

The good news, however, is that all of the China-focused funds are underweight the tech giants compared with the weighting of over 30% in the MSCI China on 30 June.

In particular, Numis analysts note the “approach of Stewart Investors, manager of Pacific Assets, means that it has no exposure to the tech giants, which have not typically met the manager’s definition of quality”.

Rotating away from tech

Perhaps the biggest surprise, according to Numis, is the low exposure of Pacific Horizon – managed by Baillie Gifford – to these stocks given the group’s explicit focus on growth.

However, over the last 18 months the portfolio underwent a significant rotation away from Chinese tech towards more cyclical companies, including materials stocks, and exposure to India was increased.

The Numis analysts looked at funds’ returns between 22 July and 28 July, when market volatility peaked. The biggest falls came in JPMorgan’s China Growth and Income fund (down by over 12% in net-asset-value, or NAV, terms) with the Baillie Gifford China Growth and the Fidelity China Special Situations trusts not far behind.

The JPMorgan fund now trades at a 5% discount to NAV while its peers are still on premiums. As Numis observes, this is odd given “its exceptional track record through a growth approach in recent years”.

We may now be past the worst. Jimmy Chen, a manager based in Hong Kong for the Comgest Growth China fund, reckons that the market has overreacted to China’s recent regulations and that the Chinese regulatory environment has not actually undergone significant change.

Many of the new or rumoured regulations should have a limited impact, including those on property, food-delivery or the internet, with only private after-school tutoring (AST) companies being severely impacted. Chen also notes that there have been regulatory turnarounds before but what’s different this time is that “the new regulations have hit
some of the large-cap growth companies and sectors owned by foreign investors”.

If he’s right, some of the worst-hit stocks in the last few weeks are now cheap. Take Tencent, which has been getting a kicking as the regulators fret about the impact of video-gaming on the young. The share price has slumped by 40% from its January peak. That puts its shares on a price/earnings (p/e) ratio of around 20, which isn’t very expensive for a diversified internet conglomerate.

The negative scenario

So much for the optimistic take. But what if this regulatory drag net is just the beginning? Ollie Parsons of investment advisor Ravenscroft says that new sectors might find themselves in the firing line. Top of his list is healthcare; witness the 20% dip over two days in the Hang Seng Healthcare Index. According to Parsons, “it is no shock to see the healthcare stocks with a technology overlap being amongst the worst hit, stocks such as JD Health International and Alibaba Health Information Technology”.

He also reckons real estate could be in the firing line – again – as policy makers worry about rising property prices. If so, that could throw a spanner in the works of the next great potential China land grab by foreign investors: the real estate investment trust (Reit) market. Asia-focused fund manager Eastspring has suggested that the rise of onshore Reits was a big positive move, providing a new financing channel “for infrastructure projects from the public to the private markets. This new asset class will widen the range of long-duration assets available to Chinese savers and supplement pension and life insurance investments.”

New property investments

Chinese regulators are even contemplating commercial property Reits (offices, shopping malls, logistics and residential housing) which could rapidly become “a $3trn Reit market, overtaking the US, currently the world’s largest Reit market and far outpacing the rest of Asia”.

Which sectors are safe?

So what should investors do now? One option is to focus on the sectors where the Chinese communists are keen
to see increased investment, some of it foreign. Chinese-American venture capitalist and blogger Lillian Li runs an excellent blog called Chinese Characteristics, which looks at what works – and doesn’t – in Chinese tech.

She suggests that we should be looking at the current five-year plan for the sectors identified as key sources of future growth. These include new generation artificial intelligence, quantum information, integrated circuits (or semiconductors), neuroscience and brain-inspired research, and virtual reality.

Will GDP growth accelerate?

Finally, consider also the wise words of a Chinese-based American economist called Michael Pettis, who writes a widely read newsletter called GlobalSource. He’s regarded as the gold standard for macro-economic analysis in China and one of his latest notes suggested that we might expect much more pump priming to get
the Chinese economy moving even faster.

Pettis observes that “while I continue to expect China’s reported GDP growth for the year to be between 6% and 8%, I am starting to believe that it will be much closer to 8% than 6%. This is because there are signs that Beijing will allow investment in infrastructure and the property sector to pick up speed in the second half of the year.”

Frightening the bearers of global capital – and struggling with the Delta wave at the same time –
might give the government second thoughts about appearing too communist. If so, we may be able to look forward to a healthy rebound in the growth rate in the fourth quarter.