Last year marked another tough year for Chinese equities, extending a prolonged era of Covid-induced pain, writes David Perrett, Co-Head of Asia Pacific Equities. Globally, investor sentiment was kept in check by the US Federal Reserve’s ongoing interest rate rises and the strength of the dollar. Meanwhile in China, worries about weak economic growth and the problems in the country’s giant property sector dented confidence – but we think there are several reasons to remain constructive.
This loss of confidence among both domestic and global investors was reflected in the poor performance of Chinese equities: much of the decline was due to de-rating rather than lower corporate earnings as risk premia rose. For the year, Hong Kong’s Hang Seng produced a total return of -10.6% and the MSCI China delivered -11.0% (both in US$), with market valuations trading at their cheapest levels since the Covid-19 pandemic. In fact, the pace of selling picked up later in the year and, amid increasingly fearful narrative from investors, has continued into 2024.
Indiscriminate selling creates opportunities
China is currently experiencing a bursting of a real estate bubble. While the authorities actively initiated this bursting of this bubble, that does not detract from the fact that the negative impact on some parts of the economy is very real and has created economic headwinds and depressed consumer sentiment. Such an economic backdrop creates risks when investing in China, however, we believe that volatile markets driven by macroeconomic concerns can create interesting opportunities for disciplined, bottom-up stock pickers.
“Looking at the China and Hong Kong equity earnings yield, we can see that valuations have reached extreme levels, last seen at the peak of the Covid-19 pandemic.”
In times of uncertainty and negative sentiment, such as those we have witnessed recently, stocks often get sold indiscriminately, which can create a fertile environment for disciplined investors to identify undervalued companies. Looking at the China and Hong Kong equity earnings yield, we can see that valuations have reached extreme levels, last seen at the peak of the Covid pandemic.
There are several reasons to remain constructive on China, in our view. We believe that pessimism about China’s fortunes and the wider economic outlook, resulting in the current sell-off, is presenting opportunities for active investors to find national and global leading companies at very attractive levels of valuation. Indeed, by focusing on near-term uncertainties and recessionary fears of weaker profits, we believe many investors are overlooking the longer-term prospects for companies that either have powerful structural tailwinds behind them or enjoy very strong competitive positions. We are also seeing both a bottom up and top down impetus for many companies to improve shareholder returns. For example, we are seeing the pace of share buybacks increase rapidly, as well as more disciplined corporate activity, with companies focusing on extracting maximum returns from their core businesses.
In addition, China is well-positioned for growth against the backdrop of low inflation, easing policy restrictions, a persistent current account surplus and high levels of domestic savings. At the same time, the yuan is relatively weak, so while demand from the West is currently low, when it does pick up, China will be very competitively positioned. A combination of low interest rates, low inflation and a competitive currency is typically positive for financial assets.
Another factor to consider is further supportive measures from the Chinese authorities. Among other moves, the People’s Bank of China (PBOC) has been easing reserve requirements for banks to bolster lending activity and cutting mortgage rates, while most recently, China’s cabinet pledged to take more measures to stabilise and strengthen market confidence, such as injecting medium-and long-term funding into money markets. Fiscal policy in terms of increased infrastructure spending should also offset some of the headwinds from weaker real estate activity.
Opportunities in the energy transition
Although there remain well known and publicised stress points in parts of the Chinese real estate market and banking system, there are also exciting areas of structural growth, not least industries tied to the energy transition. Indeed, when we think about the impediments to arresting climate change and achieving net zero, it is easy to conjure up images of polluting developing Asian metropolises and associated industrial landscapes emitting carbon through large chimneys.
As always, there is an element of truth to such popular images, but with this comes the underlying reality that if the world is going to succeed in combatting climate change, Asia will be the key battleground. Very encouragingly, in 2020 China, as the world’s largest emitter, pledged a net-zero goal by 2060. The end result of this pledge has been truly staggering: China now leads the world in the installation of both wind and – especially – solar energy1. It is also the world leader in existing installed electric vehicle (EV) fleet and production2. It is expected that renewable electricity generation (wind and solar) in China will increase seven-fold between 2020 and 2060.
Despite this strong growth and promising future, all is not guaranteed to go smoothly. Ironically, after an initial wave of positive flows into Chinese energy transition stocks, this portion of the equity market has become increasingly treacherous. Huge increases in capacity for commodity renewable items like polysilicon have ultimately outstripped demand and led to falling prices and an incredibly competitive environment where only the fittest survive. Consequently, returns on invested capital have been crushed lower.
Seeking high barriers to entry, scale, or tangential beneficiaries
Against such a backdrop, we are adopting three broad approaches to navigate the difficult environment, while still identifying stocks that should benefit structurally from the energy transition megatrend.
The first is in identifying those parts of the renewable supply chain that enjoy high barriers to entry, either through technology or regulation. We own stocks in this category which are well-positioned to benefit from decent top-line growth, while maintaining steady margins. One such example is Jiangsu Zhongtian, a niche cable maker listed in the Chinese A share market.
Zhongtian3 specialises in both making the cables and then providing the engineering services, which connect offshore wind farms to the onshore power grid. The service it provides is both complex and critical in nature and, as a result, there are only three certified players in China, of which Zhongtian is one. The scale of the offshore buildout in Chinese wind farms mean that these three cable and engineering companies are among the largest in the world, which is allowing them to win lucrative export orders in an industry that is increasingly facing ever tougher capacity constraints on a global basis.
The second approach focuses on those commodity-based producers that either have scale, vertical integration (supply their own key components at a low cost) or both, and thus have a structurally competitive cost advantage, which will allow them to remain profitable through this period of intense competition. Importantly, with general negative sentiment towards all things China at present, both groups of stocks can be bought at undemanding valuation levels.
The final approach is to identify sectors or industries that will benefit tangentially from the energy transition. Shipping and shipbuilding are two such sectors. Shipping is a cyclical sector that experienced 10 very lean years from 2010, during which boom turned to bust so that ships ordered in peak demand years arrived in a depressed market sometime later.
Looking forward, shipping – especially bulk shipping – now has a much healthier demand/supply balance. Importantly, due to uncertainty about what will be the new climate-friendly fuel standard – methanol, ammonia or hydrogen – ship owners have been reluctant to order new ships, fearing any deliveries may become obsolete before their 20 years’ useful life has expired. This is instilling an enforced supply discipline in bulk shipping that we have not seen in the past.
Similarly, shipyards are also benefiting from energy transition. During the last decade, many yards were forced to close due to a lack of orders. This has reduced both physical and human capacity for building ships. As a result, remaining yards are in a strong position to cherry-pick the most lucrative of orders, given full order books out to late 2026 or even 2027. With literally thousands of ships that need to transition in the next 20 years, it is very plausible that an historically cyclical industry like shipbuilding will resemble, for a prolonged period, a structural growth story. In the shipping and shipbuilding stocks that we own, such a positive, structural outcome is by no means discounted by current valuations.
In summary, amid all the present uncertainty, we feel that current valuations in China offer a wide spectrum of exciting, long-term opportunities for engaged, bottom-up stockpickers like M&G.
1 Wood Mackenzie, ‘China leads global renewables race with record-breaking 230 GW installations in 2023’, (woodmac.com), November 2023.
2 BNN Bloomberg, ‘How China beat everyone to be world leader in electric vehicles’, (bnnbloomberg.ca), July 2023.
3 The information provided should not be considered a recommendation to purchase or sell any particular security.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.