In the context of China’s ongoing structural transition, the withdrawal of liquidity by the People’s Bank of China (PBOC) has significant implications for markets. Over the coming months, we expect headwinds for deep cyclical, China-facing stocks across the Emerging Markets (EM) complex. We believe that this is likely to lead to a reduction in passive flows to EM, creating additional opportunities for skilled bottom-up stock-pickers to generate alpha. This article considers some of the ways active investors can play a cyclical Chinese economy through key areas of focus: slowing growth, higher costs of capital and a changing regulatory landscape.
Headwinds for miners, tailwinds for alpha-seekers
We believe that there are clear reasons why the current backdrop may support investors’ search for alpha, while posing problems for cyclically-exposed companies. First, China’s slowing growth means that its property boom (and demand for global metals) is likely to cool. While headlines might suggest that US President Trump’s infrastructure expenditure should support global metal prices, the reality is that Chinese consumption accounts for almost seven times more copper demand due to its urbanization and infrastructure development than the US, so China’s slowdown is a significant risk here.
Second, we expect to see fewer passive inflows to EM, given the decreasing tailwinds driving cyclical sectors. Indeed, we have seen significant flows into EM assets in recent years, but there is a meaningful relationship between the performance of EM cyclical sectors and positive inflows to EM equity ETFs. Our team analyzed a 5-year period in which a correlation emerged between the outperformance of EM cyclical sectors and inflows to the world’s three largest EM ETFs: the correlation was 48 percent across the period, rising to 93percent for the last 2 years. As we expect headwinds for cyclical sectors, it’s possible that beta-driven markets may give way to rich opportunities for alpha generation, amid what we believe are structurally cheap valuations on EM equities and currencies.
The third reason why this backdrop may be supportive of stock-pickers is that lower GDP growth presents opportunities for higher returns on capital, thanks in part to the necessity of an improving regulatory framework. It’s easy enough to make money when economic growth is exploding. Between 2010 and 2012, when Chinese nominal GDP growth accelerated from around 11 percent to almost 25 percent, Chinese onshore equities compounded negative returns of over 12 percent annually, where the explosion of new fixed capital contributed handsomely to growth. But from a corporate perspective, excess capacity creates deflation and diminishes margins, and an artificially low cost of capital reduces incentive for management to make proper returns. This was the era of such projects as the 90-day-to-build, 220-story pre-fabricated ‘world’s tallest building’ in the Chinese countryside; a 3-year period in which China consumed more cement than the US did in the entire 20th century. Now, Beijing has encouraged supply-side rationalization of material sectors, such as coal, steel, aluminum, in order to lift returns, which has been successful. For example, Baoshan Iron & Steel, China’s biggest steelmaker doubled its returns last year.
However, there are other less high-profile areas that have also benefitted from this rationalization, such as electric and hybrid buses. China had previously offered generous subsidies to encourage the adoption of ‘green’ buses, meaning all players in the sector could make a return, irrespective of product quality or efficiency. But now, Beijing has changed this regime to foster greater efficiency and reduce corruption. Following a one-off hit to pricing in 2017, we expect three market leaders to gain market share and pricing power.
Alpha Opportunities in Emerging Markets
Ultimately, we believe that the headwinds facing cyclically-exposed companies may present opportunities for stock-pickers, and that the changing landscape in China should radically differentiate winners from losers, with huge scope for incremental market share and returns for the winners: a backdrop that can foster a true bull market in stock-picking in China. We believe that A-shares are one of the most liquid, inefficient opportunities in global financial markets, virtually untouched by foreign investors and on the cusp of a revolution in returns on capital. MSCI’s recent decision to revisit index inclusion may well be coming at a time when the bottom-up story in China is getting far more interesting.