Not the end of capitalism in China

Nick Payne, Head of Strategy, Global Emerging Markets Focus and a longtime investor in China, analyses the government’s recent regulatory crackdowns on the education and technology sectors that unnerved financial markets. He suggests that the best companies will adapt to these changes.

 

The private sector is a massive growth engine for the Chinese economy – it is responsible for around 80% of job creation — and if you squeeze entrepreneurs too much, they’ll leave the country. The ruling Chinese Communist Party (CCP) knows the importance of improving living standards and that state capitalism has been the main way of doing that.

 

You are seeing a shift by the government in this 100th anniversary year of the CCP. The party announced it achieved its goal of eliminating poverty, and there is now a change in emphasis from growth at all costs to growth with sustainable outcomes and that is socially inclusive. China also is more focused on improving its national economic security, particularly given the US trade war.

 

The regulatory cycles that we’re seeing are not new. The clampdown on private education companies that has caused a lot of concern in the market is different, but President Xi said several years ago that he did not like private capital in this area. It conflicts with the state’s goals such as improving the birth rate and social equality. That you could buy your way to a better outcome with private tuition didn’t play well.

 

The regulatory tightening aimed at big tech companies has been about protecting individual data privacy along the lines of GDPR rules here and also about improving the labour code and strengthening anti-trust rules. Many of these policy announcements are following the right lines and reflect the fact that companies have innovated, disrupted, and moved much faster than the regulations have.

 

The best companies have also been very elastic in moving and adapting to the changing regulations. China will continue to be a key source of investment opportunities for our strategy, but it’s undoubtedly the case that the discount in China has to increase given some of this policy unpredictability.

 

It is also a reminder that in China you must invest in alignment with the government’s plans, including its five-year goals. If you invest against that you do so at your own peril.

 

Lastly, it’s worth noting that Covid cases are picking up in China, especially the Delta variant. China has been relatively successful with its containment and vaccine rollout but there’s still a large part of the population that is not vaccinated. If the variant spreads in China, we are likely to see more policy easing. China started easing policy gently about three weeks ago with cuts to reserve requirements for banks.

 

Reflation may try to make a comeback

Joseph Chapman, Assistant Fund Manager, Multi-Asset, says the continuance of fiscal and monetary support is positive for risk assets, and he doesn’t expect a taper announcement from the Fed before December or early next year.

 

US company earnings so far have been very strong. With over three quarters of the market reported, 88% have beaten consensus estimates. On average, beats aren’t rewarded at all. Investors are focusing instead on companies’ forward guidance, which has been more muted.

 

Crucially, for the reflation narrative, profit margins have increased. This has been backed up by pricing power surveys we monitor showing companies are confident that they can pass on higher input prices.

 

And the main event in the calendar for last week was the Federal Reserve (Fed) meeting. The Fed added to their statement that “the economy has made progress towards our employment and inflation goals” since the last meeting. However, they also said that they will continue to monitor progress in the coming meetings. For us, this takes off the table the possibility of a September Fed announcement about the tapering of monetary support and pushes our base case of a taper announcement to December or early next year.

 

The Fed maintained a narrative of higher inflation numbers being transitory, but we think it’s worth noting that while some of the volatile components may recede, owners’ equivalent rents have been ticking higher and may provide some longer lasting pressure.

 

We don’t see the Delta variant of Covid as making a significant impact on the pace of reopening as thanks to vaccinations hospitalizations remain low.

 

So, for now, fiscal and monetary support remains in place, which is positive for risk assets and as we move into the back end of the US earnings season, companies will be able to return to the market with buybacks adding a pillar of support.

 

Put it all together, we think there’s room for the reflation trade trying to make a comeback over the next few months, and we’re still positioned for it, albeit with a reduced level of risk across our funds.

 

The value of active minds: independent thinking

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