Whilst investors are warming to the relative attractiveness of emerging markets versus developed markets, China remains a source of intense debate. This is reflected in the 37% decline in the Hang Seng Index over the year to 31 October 2022, making it amongst the worst performing major markets in the world. October was particularly bleak, with the market clearly unsettled by the Party Congress held in this month, where there was a clear consolidation of power around President Xi.
Indeed, the outcome of the Congress was somewhat surprising when we consider the extent to which Xi has tightened his grip, in doing so pushing aside conventions on term limits, traditional career paths, age limits etc. On the other hand, it was not totally unexpected given the pattern towards centralisation we have seen in recent years. Furthermore, none of the actual policies that were outlined in the Congress’ working report were a surprise, mainly continuing in the same tone we have seen over the past few years, the emphasis being on things like higher quality and more equitable growth; dual circulation; high-tech development; skills investment etc. Xi described the main goal of his government as marching “on all fronts through a Chinese path to modernisation”, with “high quality development” as the primary task.
For sure, the emphasis of economic policy will shift, with more focus on quality of growth rather than quantum, and more attention will be devoted to so-called ‘imbalances in development’ such as severe lack of affordability in housing and access to education. It is worth observing that these items are also usually high on the agendas of most progressive European governments.
Moreover, the implied rate of growth (4.7% GDP growth per annum) being targeted in the run up to 2035 is still pretty robust by most standards. It seems hard to imagine this objective (and the others mentioned above) being met if the private sector (60% of GDP) is significantly handicapped, especially businesses such as our holdings which are committed to developing domestic consumer demand, something which is a priority for the leadership as they seek to reduce dependence on exports and fixed capital investment as the main drivers of Chinese growth. Indeed, there are numerous references in the Congress Report to the ‘decisive’ role of the private sector in resource allocation – hardly a formula for hardcore socialism!
The appointment of Li Qiang as Premier may also be reassuring in this regard, given his generally pro-business stance when he was running Zhejiang, Jiangsu, and Shanghai (prosperous regions in East China’s economic powerhouse). His achievements include bringing Tesla production to his region and to China, as well as setting up the Star Market (China’s equivalent of NASDAQ). Apparently Li helped to act as an intermediary for tech company tycoons such as Alibaba’s Jack Ma when Xi cracked down on private enterprise in 2021. His appointment was surprise to some, given his lack of experience at the national level governance, but could be a sign that Xi still values entrepreneurship and innovation. We should also recall the oft-stated truism that the CCP bases its legitimacy on economic performance, and hence it seems very unlikely that they would readily abandon a growth formula that has worked extremely well over the past four decades.
On Taiwan, Beijing’s explicit preference remains peaceful reunification, but (somewhat obviously) the military option will not be taken off the table. For what it’s worth, our view on this is that a planned military invasion seems unlikely – this would entail massive risks and uncertain outcomes. Russia’s debacle in Ukraine has illustrated these dangers. The priority of the CCP is domestic stability and getting the economy back on track post COVID – it is hard to see how high-risk military adventurism would serve these goals. One hint at this was the demotion of Le Yucheng, who was the architect of the now infamous ‘friendship without limits’ Russia policy. Military expansionism is clearly not the top priority for the CCP. That said, an accidental confrontation or miscalculation around Taiwan is certainly possible, which could lead to a spiral of escalation.
Reflecting on the Congress, the main concern from our perspective is not so much some sort of lurch to militaristic communism, but rather the effect of the leadership changes on the quality of China’s decision-making with so much authority now centred around a single individual. This is in contrast to the more collective ‘bureaucratic authoritarianism’ that prevailed before. We happen to believe that collective decision-making is better than individual decision-making (indeed, we have structured our own investment process around this principle). We acknowledge that this individualisation of power in China is a risk but find some reassurance in the composition of the Politburo and the wider membership of the Central Committees, which seem to be stacked with competent people typically from finance, technical or economics backgrounds. We should hopefully get some more clarity on what this all means in terms of translation to policies over the next year, with the Central Economic Work Forum later this year and the Two Sessions being held in March 2023.
What does this mean for our China allocation? Not a lot at this stage. The fundamentals of our holdings remain very solid, and we think they are unlikely to be affected by foreseeable policy developments given the type of business models we favour (simple, everyday consumption in industries not reliant on political favour). We will of course continue to monitor the risks outlined above and will take corrective action if any of our assumptions above begin to look markedly wrong – our China stocks are sufficiently liquid that we can quickly rebalance away from the country should we see a situation arise akin to what we saw in Russia in December 2021. Whilst we are strategic investors who do not take ‘calls’ on geopolitical factors, we will take appropriate steps to manage these risks.
That notwithstanding, the primary focus of our attention is on more ‘knowable’ factors, specifically company fundamentals and valuations. We target long-term and highly visible structural trends, such as digitalisation, the consumption upgrade, ageing populations, and the climate change transition. We own businesses that have always placed strong emphasis on ESG, which in the Chinese context is proof of social utility, meaning the risk of political interference is lowered. In fact, we think our holdings are very well-aligned with what Beijing is trying to achieve, without being dependent upon government favour. For instance, the Congress Report emphasised the desire to strengthen domestic consumption and supply chain structures, which is literally the core purpose of JD.com. Operating results for this holding, and most of our other China names, have been solid. However, the degree of derating we have seen over the past year would indicate the market is pricing in an utterly bleak medium-term outlook. For instance, JD.com now has an implied EV/EBIT ratio for its core retail operation of just 8x, despite operating earnings growth for this division expected to be around 20%.
Whilst the policy risks associated with China – increased centralisation and Taiwan concerns – are greater than was the case a few years ago, we believe that a good amount of this risk has already been priced in for our holdings. Meanwhile, at the risk of oversimplifying, China is still a very large, strong, and growing economy, and will remain so for the foreseeable future. We continue to believe that for investors who pick stocks wisely, the current dislocation between intrinsic value and share prices in China could present a rare opportunity.
 JD.com financial reports, Bloomberg, Arisaig analysis
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