FAQ: Managing China equity exposure

China’s equity market has underperformed in recent months, driven, most notably, by regulatory pressure on the tech and private education sectors. The MSCI China index delivered negative returns of -14% in July, compared with a 0.7% positive return for global equities.

The most recent action has been directed at the private education sector and is more far-reaching than earlier scrutiny on tech companies, which focused on issues ranging from anti-trust to privacy issues. The Chinese government has issued a clear directive that all existing after-school tutoring (AST) entities operate on a non-profit basis, which has effectively wiped out the related equity in the sector. The government has also disallowed the use of foreign capital in the sector and banned the advertising of AST services.

With investors seeking clarity on the regulatory outlook, we have aimed to answer some of the most frequently asked questions:

1. Will other industries also be compelled to go non-profit?

• We don't think so.
• We see a difference between Beijing’s intervention in the AST sector and the recent regulatory campaign in the new economy segment, for example. The Chinese government has emphasized that education is a public good and sees reining in the AST sector as part of its aim to lessen the financial burden on parents with school-age children and lower the disincentive for them to have larger families. For the tech sector, Beijing remains focused on its long-term goal of technological self-sufficiency and leadership on the global stage. Hence, we don’t expect the government to turn the internet sector non-profit, for example. Even though we believe regulatory risk will continue in the socially sensitive sectors of property and healthcare, we don’t expect the government will push these sectors to non-profit either.

2. Is the move toward tighter regulation now complete?

• Not yet.
• China’s central bank and top government policymakers over the weekend warned that the regulatory clampdown on some sectors will continue. We still believe further restrictions are possible in parts of the new economy, property, and healthcare. Given the proposals introduced over the past 12 months in the new economy we believe that Chinese regulators are already level with or even ahead of global peers in areas such as ride hailing, food delivery, ecommerce, and fintech. However, China may still be behind its developed market peers in data privacy and security. Stricter regulation in these areas could affect the planned monetization of clients’ data. In China’s property market, which policymakers regard as closely related to people’s welfare, our base case for the rest of the year is that Beijing will continue to curb home and land price increases through tight property-related financing policies. In healthcare, while we don’t expect substantial incremental policy risk in the sector for the rest of 2021, tighter price controls on medical consumables and devices are possible. These have the potential to trigger a derating of the sector.

3. Are there still investment opportunities in offshore Chinese equities?

• Offshore equities are pricing in a higher risk premium. This is likely to linger in the near term. However, we think future returns will be largely driven by earnings growth (mainly from cyclical and value sectors) this year. We recommend investors cherry-pick stocks across sectors that are supported by earnings growth but have limited regulatory risk exposure. Our preferred sectors include consumer durables and services, energy, and greentech. More broadly, we still prefer the cyclical and value sectors that will benefit from the reflation and reopening of global economies.

So, although we remain positive on the medium-term earnings and valuation prospects of Chinese equities, we see regulatory risks remaining and clouding the near-term outlook. We are neutral on the Chinese market.

Investors should review their total portfolio exposure to China following the recent erosion in equity prices. Investors who are under-allocated may consider using the recent underperformance to gain exposure to the sectors and themes we prefer within China. For investors with overly concentrated exposure, CIO recommends rebalancing overall exposure and tilting it toward their preferred areas, making exposure more defensive, or broadening exposure to the rest of Asia, US or Europe. Click here for more on positioning for reopening and recovery and here for opportunities in Asia.

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