China’s regulatory crackdown: cultural revolution or state-engineered rebalancing?

The changes seen in China have impacted markets beyond the county's borders. As we look into what the new regulations are and how they have caused a significant retreat in Chinese equities, we also ask what the reasoning behind this stream of new rules might be.

Commentaire Mensuel
19 Août 2021

The changes seen in China have impacted markets beyond the county’s borders. As we look into what the new regulations are and how they have caused a significant retreat in Chinese equities, we also ask what the reasoning behind this stream of new rules might be.

The month of July proved to be a busy month on the regulation front in China, leading to a significant pullback in Chinese equities. Edouard Bouhyer, a Banque Eric Sturdza Investment Committee member, provides the latest investment insight on China.

A busy July on the regulation front

Like the US and Europe, China is facing the same issues that big internet platforms are posing everywhere: data privacy, monopolistic behaviours, invasive presence in day-to-day life and growing involvement in key areas such as Financial Services, Education, AI Technology. But its reactions have been stronger and faster.

The topic is not new in China: restrictions imposed on online gaming in 2018, ANT’s IPO cancelled in 2020, Alibaba fined for monopolistic behaviour in Q1 to name a few. This also explains the discount at which Chinese internet giants are trading despite their solid growth prospects.

However, the flood of announcements in July has nonetheless shocked most investors, before markets started to stabilise at the end of the month when Chinese authorities started to communicate to reassure local and foreign investors.

Timeline – China’s Regulatory Crackdown in July and August 2021
China-July-Timeline-2021-4x1-5

Source: Banque Eric Sturdza, Bloomberg, Reuters.

Market implications

No surprise in such circumstances to the Chinese stock markets erased in July more than $1,000 billion worth of market value, a sharp contrast to developed markets at record highs.

But not all Chinese stock markets are created equal… The Chinese ADRs – Chinese stocks listed in the US – were hit the most, closely followed by Chinese stocks listed in Hong Kong. Interestingly enough, Chinese stocks listed in Mainland markets fared much better.

July’s performance of various Chinese assets
China-July-Performance-Chinese-Assets-4

HSCEI Index (Hang Seng China Enterprises Index) Chinese stock markets. Daily 28J. Copyright © 2021 Bloomberg Finance L.P. (11 August 2021).
Source: Banque Eric Sturdza, Bloomberg.

Flows into A-shares through the Hong Kong Connect were also positive in July, highlighting no signs of panic in Mainland markets notably from foreign investors.

The Yuan barely moved during this downturn, and the performance of Chinese Bonds continued to be positive. These two factors also highlight continued confidence in the continued opening of China’s capital markets.

Game changer or return to normal?

China VC Tech Investments in 2020

Source: Prequin, Bloomberg, USD bio.

Investors are questioning the motivations of the Chinese Communist Party (CCP) to punish the Chinese New Economy champions, especially at a time when US authorities are also making it more difficult for Chinese companies to raise capital in the US. These moves and political interventionism, albeit quite disturbing for investors, are not new in China and also explain some of the discounts applied to Chinese assets vs. US ones.

As a key in the competition opposing China to the US, the Chinese internet companies have historically been favoured by the Chinese authorities – protected domestic market, preferred tax treatment, etc. – leading them to own monopolistic market positions in different verticals. Such companies were also at the forefront of Chinese Venture Capital (VC). In that sense, the CCP actions look more to be a return to normal and a rebalancing than the unwinding of the sector.

These moves should also be viewed in light of the Chinese strategic priorities more targeted at artificial intelligence, autonomous driving, semiconductors than consumer-facing applications and social networks…

Adjusting LT goals to new expectations

If investors were smashed in the short run by the authorities actions, investors should not consider the Chinese equity market as uninvestable.

Chinese stocks are poised to benefit from its growing economy and a wealthier and increasingly middle class. However, investors should also consider the following factors:

  • ‘Political’ discount to apply to reflect the uncertainties around the legal setup and the moving parts there. Sadly this is not the only market concerned by this discount factor.
  • State interventionism is not to be underestimated. In areas deemed strategic, it may cap profitability and damage some industries. As an example, the hard-to-understand ban on private tutoring firms should be considered, as education cost is the primary factor quoted by Chinese households for not having more than one child.
  • Increasingly, investors willing to invest in China have to comply with the Chinese rules and set up. Interestingly enough, China’s authorities reassured investors when the panic started to spread to the local A-share market.
  • Even if Chinese internet champions may be dead money until the dust settles, their multiples have already derated and reflect somewhat the increased risks on their profitability and growth prospects. The valuation gap with their US equivalents is significant.
Table – Baidu, Alibaba, Tencent metrics vs. US equivalents

Company

Market Cap

YTD

2021 P/E

2021 EV/Sales
Revenue Growth
5Yr CAGR
EPS Growth
5Yr CAGR
Baidu 56 -26.2 16.2 2.3 10.0 1.5
Alibaba Group 519 -17.7 21.0 3.2 48.0 24.3
Tencent Holdings 595 -14.5 27.3 6.8 36.2 33.3
Average 390 -19.4 21.5 4.1 31.4 19.7
Alphabet 1830 56.6 27.3 8.4 19.5 17.6
Amazon 1670 1.43 62.6 3.6 29.3 101.5
Facebook 1002 32.8 25.9 8.1 36.8 50.9
Average 1501 30.3 38.6 6.7 28.5 56.7

Source: Banque Eric Sturdza, Bloomberg, 08/12/2021.

Update on the Strategic China Panda Fund with the IA, LBN Advisers

Performance Attribution: In July, the Strategic China Panda Fund was impacted by the market drop and its position in Education stocks but did remain largely ahead of its index YTD and over the long run. The opportunistic profit taking done early in the year by the PM in the Internet sector and the redeployment in more cyclical oriented industries (Shipping, Logistics, Tech Components) and Banks explain the relative outperformance.

Regulation: Even if state interventionism is not new, the regulatory push notably in the Education sector was out of expectations. The Fund’s exposure to the Education sector (2%) was a big detractor. Post announcement, the remaining exposure was kept and switched into New Oriental Education which has higher revenue in non K9. With regulatory attacks over monopolistic behaviours by some internet companies, visibility will remain very poor and earnings will be under pressure, the PM prefers to wait for the dust to settle on interim results by mid-August to get clearer visibility from companies.

Strategic China Panda Fund USD vs. MSCI China USD NR – YTD
SCPF-Vs-MSCI-Performance3

STCHUSI ID Equity (Strategic China Panda Fund) Peer Group. Copyright © 2021 Bloomberg Finance L.P. 13 August 2021. Source: Banque Eric Sturdza, Bloomberg.

 
1M

3M

YTD

2020

2019

2018

5YR Ann.

Vol 3YR Ann.
Strategic China Panda Fund – B USD -12.04 -2.26 -4.03 23.43 29.20 (20.97) 14.39 23.52
MSCI China NETR USD -7.43 -4.39 -10.14 29.49 23.46 (18.88) 11.28 22.06

Positioning: Short term a more defensive positioning is adopted. The cash level has been raised to 9-10% waiting for additional visibility and better entry points in growth sectors. Communication Services, Healthcare and Real Estate (profit taking) were reduced. At the same time, Financials mostly Banks (trading call) have been increased (+5%), and the Fund’s exposure to the Home Appliance group.

A Shares: The Fund has little if no exposure to them and is not intended to increase the exposure outside of industry groups such as Wine and Spirits barely represented in H shares. So far, LBN Advisers have favoured more attractively valued opportunities in more institutionalised market segments.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 13/08/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.