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Research

Less Directional But More Relative Value Opportunities in China

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Economic data portray a sustainable growth in China, but it’s still unbalanced and plateauing. It remains driven by manufacturing and exports, but consumption lags, and impacts from ongoing authorities’ targeted deleveraging and reforms are starting to show. They are focused on corporate debt, real estate and corporate dominant positions in internet and fintech, and more recently on retail access to commodity-linked investment products. While authorities are unlikely to overshoot, growth would be capped. Chinese equities seem to be bottoming after a steep correction. However, past a technical rebound, stocks might be rangy, constrained by a mixed economic news flow and fair valuations. 

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Less Directional But More Relative Value Opportunities in China
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While stock opportunities might be less directional, alpha is improving. Market exuberance earlier this year has moderated, providing a more stable ground for stock picking. We find that the market structure has also substantially changed, with reduced and shifting sector cyclicality (see table below). Sectors’ traditional allegiance to rates, currency and factors also abated. Moreover, the share of stock returns explained by idiosyncratic drivers soared. All these trends are consistent with increased fundamental pricing and more diversified and decorrelated set of themes, amid more affordable valuations.

Managers within our peer group of Ucits funds have been dynamic in their exposures. After the vaccine announcements, they had favored offshore exchange and export-driven stocks, before turning to stocks sensitive to domestic demand early this year, including healthcare and retail positions. While remaining long, managers are now back in stocks sensitive to external demand (concerned by domestic constraints) and allocate to areas where stimulus are likely to remain, in infrastructure in particular. They also reweighted, to some extent, businesses positioned on new consumer trends as well as stocks listed overseas. Meanwhile, they have steadily sold off their tech exposure, caught in the crossfires of US-China tensions and anti-monopoly offensives. Exposures to quant factors do not appear to be key allocation drivers. Overall, they have produced modest alpha year-to date and have been resilient during the correction. High correlation and average dispersion across managers’ returns suggest relatively homogeneous positioning but differentiated in sizing.

Structural patterns also support alpha in China. First, a widening market access and a heavier share of China in EM and world indices would still attract flows. Second, market depth, crucial for alpha, would further progress, driven by a broadening set of businesses, types of investors, and corporate operations. Besides, inefficiencies in onshore exchanges still provide arbitrage. Third, multiple themes generate catalysts, including the transition from an export to a consumption model, a rapid urbanization, the rise of innovation leaders in tech and beyond, an ageing population, the green transition, the enhancement of corporate governance etc. In nuance, alpha remains vulnerable to geopolitics and policy-driven changes in stimulus, credit, regulations, stock short suspensions. Elevated corporate debt also requires serious risk management

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