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Blogs

China: Growth optimism despite geopolitical tensions

Dan Delany and Matt Scherer

August 12, 2021

The Chinese government has recently escalated regulatory oversight of certain sectors and foreign listings. While this may be a cyclical phenomenon, the intensity of the current period may have some investors questioning the growth tradeoff in this market.

What is going on?

Over the course of the last six months, the Chinese government has escalated regulatory oversight of certain sectors and foreign listings. This is a cyclical phenomenon. Over the years, we have experienced periods in which the government increases regulation or reprimands business leaders. The current period is, however, the most intense we have seen in thoroughness and breadth.

At the company level, we have observed regulatory action typically taking approximately eight or so months to resolve. It is important to characterize regulatory events to assess their duration and threat to business models. We would characterize the Chinese government’s recent actions in four categories:

  • Antitrust actions: Merger and acquisition activity scrutinized; ecommerce platform activities in relations to sellers and goods; ride hailing and delivery platform relationships with respect to drivers/employer status.
  • Financial technology (fintech): Initial public offerings (IPO) pulled, and new economy bank’s operating policies scrutinized.
  • Security: Regulatory concerns regarding data security outside of China.
  • Equality: Education stocks, the prohibitive cost of raising a child in China, and the central government’s desire to increase the birth rate.

What are we doing?

We are monitoring the situation closely and are using this period of geopolitical volatility as an opportunity to buy the highest quality companies at attractive levels. We believe our approach of investing in quality companies with defensible business models and predictable earnings, underpinned by strong balance sheets is the most effective way of achieving attractive long-term track records.

In the most recent Five-Year Plan from the Chinese Communist Party (CCP) released in March 2021, the continued growth of the technology sector, e-commerce and fintech all featured prominently in the party’s overall growth objectives. This leads us to believe that the recent anti-trust actions will be transitory and are only a means to reaffirm the party’s dominance in the eyes of executives at these large firms. Given the state of most Chinese state-owned enterprises, it should be very clear to the party that they cannot accomplish these goals on their own.

Valuations in the tech and internet sector now look quite attractive relative to history and especially relative to the US tech sector. The tech and internet sectors in China have lost more than a third of their value from their peak putting them solidly in bear market territory. While it is difficult to call a bottom, further significant downside seems to imply the most draconian of outcomes.

What about delisting of Chinese shares in the US?

For multiple years, the threat of delisting has loomed. Former President Donald Trump’s administration accelerated the discussion by requiring the Public Company Accounting Oversight Board (PCAOB) to have access to audit firms’ reports, which China does not allow. This could result in delisting of Chinese stocks traded via American depository receipts (ADRs) in 2024 if nothing changes. This situation is also fluid, as PCAOB leadership is changing under President Joe Biden’s administration.

We believe it is still too early to determine the outcome of delisting. This will likely take years to play out, rather than weeks or even months.

Is exposure to China attractive over the long term?

The growth of the Chinese economy is responsible for most of global economic growth in the last two decades. Going forward, China remains behind other nations in terms of gross domestic product per capita, a gap that should narrow. The continued growth of the middle class in China and the leading position of many of its technology companies, should offer active investment managers access to strong revenue and earnings growth.

That said, China remains an emerging market, particularly in relation to the authoritarian regime that governs it. We expect to continue to see periods like the current regulatory cycle, which may appear arbitrary and undemocratic to Western investors. To a degree, these periods of volatility are in some ways the price paid for accessing Chinese growth.

We will continue to monitor and keep investors apprised of the evolving economic situation in China. If you have any questions, please do not hesitate to contact a member of your CIBC Private Wealth team.

 

Dan Delany, CFA and Matt Scherer, CFA co-manage the International Growth strategy, which focuses on high-quality international companies that sustain higher-than-average earnings growth over extended periods of time. The strategy employs a fundamental bottom-up stock selection process while maintaining sector and geographic awareness.