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China: The Ugly Duckling?
Markets with improving fundamentals and liquidity but weak investor sentiment are ripe for investments
Steven Luk 1 Jun 2023
Steven Luk, CEO of FountainCap
Steven Luk, CEO of FountainCap

Navigating a divided world is increasingly difficult for capital allocators. The 24-hour news and social media that are ubiquitous today make rational and effective decision-making even more challenging. One of the topics often discussed among global allocators relates to China and its role in a portfolio. With geopolitical tension dominating headlines around the world, there's a natural tendency to insulate a portfolio by reducing exposure in areas with significant perceived uncertainties.

However, I would argue that staying invested and exposed to China can pay handsome dividends to an investment portfolio, especially over the long term. We believe markets with improving fundamentals and liquidity, while investor sentiment is still weak, are ripe for investments. Conversely, markets with deteriorating fundamentals and liquidity, while investors are still heavily exposed, should be avoided.

Asset allocation inevitably needs to consider the macro environment via a top-down approach; as such, it is better to view the macro environment in cycles rather than through the lens of any specific event. In this context, it is hard to ignore a recovering China and the start of a new market cycle, given the selloff over the past few years. In fact, every time over the past 30 years that the China market has gone through a significant downturn, a prolonged bull market (lasting on average 4.5 years) has always followed. General investor sentiment towards China is still depressed, yet this forms a good basis to stay exposed or increase investments.

We have always maintained that fundamental investing in China requires not only a deep understanding of how a company runs its business but also a correct understanding of the political landscape. The importance of this dual analysis is best highlighted during the most recent regulatory changes in sectors such as education and the internet, with the former experiencing nearly a complete collapse. Yet if political factors are only considered, then state-owned enterprises would logically be the preferred investment choice, but most would not have yielded anywhere close to the value generated by the private sector over the years.

Furthermore, given how the market dynamic has changed in this new cycle, the top-weighted names in China-specific benchmarks may no longer be a good representation of China's future growth. As such, active and direct exposure to China will work much better than passive and indirect exposure, given the nuances required in navigating the China market.

Despite the economic slowdown in China, investment opportunities still abound. Even if China slows down its growth to only 5% this year, the dollar amount of that growth still represents over 30% of global GDP growth. Its US$18 trillion economy is the second-largest in the world and accounts for nearly a fifth of the global economy.

There are sectors that are still significantly underdeveloped and will experience substantial growth in the years to come. For example, China currently has fewer than 1/3 of ICU beds per 100,000 people compared to the United States while having over 4x the population. New infrastructure will also continue to drive economic growth as the country modernizes. It currently has fewer than half the amount of railways per 1 million people compared to the United Kingdom and less than a quarter when compared to Germany. The same can be said for motorways, as China has only a third of the amount of motorways per 1 million people when compared to the US. Traditional infrastructures are not the only ones being prioritized, as the country aims to ensure nationwide 5G coverage by 2025 and build 20 artificial intelligence (AI) innovative trial zones before the end of this year.

The current consumption recovery taking place in China is much more organic in nature than the more stimulus-driven recovery witnessed in other developed markets. And similar to any organic produce, it will not be perfect in shapes and sizes. However, it is hard to argue that a positive trend isn't forming. Travel and entertainment-related industries are experiencing a significant rebound in activity. Recent consumption data over the Labor Day holidays surprised on the upside, with travel bookings on the largest travel platforms in China surpassing the 2019 level. Hotels in the most popular tourist destinations reportedly raised room prices more than tenfold. Over 130 million passengers traveled through the national railway system, representing an increase of 27% when compared to the same period in 2019.

Alipay released transactions data for the Labor Day holiday, and the dollar amount spent through the payment platform increased 230% when compared to 2022 and increased 70% when compared to 2019. Transportation services on the app saw the number of transactions growing 2.2x, while overseas average dollar spent grew 40% when compared to 2019 levels. Reflecting the strong statistics reported, corporations across various consumption-related industries with different segments of consumers, ranging from mass-market to luxury, reported strong quarterly results that highlighted households' willingness to spend.

A senior British official recently visited Hong Kong as part of a trip to attract investments into the UK. This visit marked the first official trip by a senior British official in five years. I was fortunate enough to join him at the Hong Kong British Consulate, where I shared with a group of local executives in the asset management industry the opportunities available for international collaboration. The topic of geopolitical tension and deglobalization was inevitably discussed, and to the delight of many in the room, it was implied that the UK has no intention to decouple from China. In fact, many businesses are looking to re-engage with China. Such developments echo the actions of many other corporations from the US that are setting up wholly owned subsidiaries and investing heavily directly in China. There is a divergence between what headline rhetoric states and what private businesses are actually doing.

While preparing for this discussion, I wanted to understand how many S&P 500 companies derive their revenue from overseas. It turns out that 312 companies within the S&P 500 have more than 10% of their revenue contributed by international businesses. Of those companies that provide a further breakdown of their geographical revenue sources, 45% have more than 10% of their revenue contributed by the Asia-Pacific region. Of those 140 companies with significant Asia-Pacific businesses, 54 companies have Greater China operations that contribute between 2% and 65% of their revenue. The companies with the most business in Greater China are information technology firms such as Qualcomm, Texas Instruments, Nvidia, Intel, and Micron Technology.

Certainly, the reported number of companies with Greater China businesses is likely understated, as many do not provide such a breakdown in their financial filings. For example, the APAC region contributes more than 10% of Morgan Stanley's revenue, but the company does not disclose its Greater China exposure. However, given that the bank is establishing its wholly-owned mutual fund business and a futures trading company in China, it is safe to assume that the Greater China regional revenue contribution will be significant and likely serve as the growth engine for the company going forward.

If we examine each company's supply chain, the business entanglement between foreign companies and China becomes even clearer. In fact, a recent article in the Financial Times boldly calls Apple a Chinese company. If tension remains high and a full decoupling were to occur, its effect may be equally consequential for the US economy, given that the large American companies in the S&P 500 index account for over 70% of employment and capital investment, and represent over 80% of available market capitalization.

This analysis may be an oversimplification of the matter, but the exercise makes me ponder whether many asset allocation models are still reflecting factors and using assumptions that are based on an era (since the GFC) and environment (low inflation, lower rates, relative geopolitical calm) that are no longer applicable.

Steven Luk is the CEO of FountainCap Research & Investment (Hong Kong) Co., Ltd.

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