How should institutional investors approach China?
By Anja Needham, CFA
China made the headlines for all the wrong reasons in 2021, as slowing growth, defaults in the highly levered real estate sector, and an apparent move by the government to focus on social priorities above growth – including the introduction of investor-unfriendly regulations impairing certain sectors with little warning – all combined to damage investor confidence. While we believe increased investor nervousness over China is warranted – the reset currently taking place in China is big and, at a minimum, has significantly increased the risk for investors – there may still be potentially interesting opportunities for investors in China, with the key question being whether current valuations adequately compensate for the perceived risks.
Some say that following this recent period of turbulence, valuations are attractive for many Chinese assets – representing a possible source of strong returns in an environment where high global equity valuations, tight credit spreads, low bond yields and waning Developed Market monetary accommodations leave little room for upside in the global markets more generally. While there is an expectation for substantial default activity amongst real estate developers, there is also strong potential for consolidation and rebounds amongst survivors, presenting attractive distressed opportunities. The market is pricing in a 12-month default rate of around 30% amongst high yield Chinese real estate developers, which many experts view as significantly over pessimistic. Many high quality names are suffering by association, and are attractively valued considering their fundamentals and market exposure. Meanwhile, the base case is for Chinese property sector concerns to stay contained, particularly as Chinese banks have limited exposure.
As an additional consideration, recent years have seen China added to global fixed income indices (China’s stocks have been part of global equity indices for many years) and becoming a significant part of the benchmark exposure for many institutional investors. For example, the FTSE Russell World Government Bond Index began a phased introduction of China’s bonds into their index from October 2021 – by September 2024 this is expected to result in a China weight of around 6%, driving approximately $140bn of inflows from passive and benchmark-oriented strategies. Investors therefore need to carefully consider the potential tracking error that could be introduced by avoiding investment in China.
As we see it, investors have three options with respect to managing their exposure to China: they can take advantage of the currently attractive valuations using specialist managers, accept benchmark exposure, or avoid it entirely.
We believe the first option makes the most sense for managers with in-depth, specialist knowledge in Chinese assets and the Chinese regulatory environment, who are best placed to assess whether valuations are a fair representation of risk. In particular, the market is pricing in a 30% risk of default for high yield real estate developers, which many view as overly pessimistic. This approach could be well suited to specialist debt or distressed managers who can potentially take advantage of the current market turbulence and dislocations to generate strong returns.
The second option may make sense for managers who do not wish to use their active risk budget on taking a view on Chinese assets – if they are not China specialists, they may prefer to keep the benchmark weight and deploy their active risk budget elsewhere, especially for indices where China has a large weight, and a zero weight could lead to significant tracking error. This could be a good option for managers such as those running Local Currency EMD Sovereign mandates, where China now has a 10% weight in the most used benchmark (JPMorgan GBI-EM Global Diversified).
The third approach may be the most sensible for some investors, particularly for global fundamental equity managers who do not specialise in China. If their investment approach is to value stocks using an in-depth bottom-up analysis of a company’s fundamentals, and there is a risk of Chinese government interventions that can render their investment thesis void without warning, it is understandable that they may prefer to avoid this source of risk. The MSCI ACWI index has a China weight of 3.6% (as of 31 December 2021), so global equity managers benchmarked against this index, for example, may be able to accommodate a zero weight to China in their active risk budget.
In conclusion, the best way for investors to approach China depends on the asset class in question and whether underlying managers are global generalists or China specialists. For those looking to take advantage of potentially attractive valuations, exposure through alternatives – particularly specialist distressed managers who may stand to benefit from turbulence in the real estate sector – may be an effective way to gain exposure.