China 2021: An under valued equity market

24 January 2021

China is under valued by investors and presents exciting opportunities in 2021 for numerous reasons, says Min Chen, head of China and lead manager of the Somerset China Strategy, Somerset Capital Management. But there are factors to consider.

2020 was an unprecedented year for China. US-China tension dominated headlines and caused disruption to many industries. To combat Covid-19, Chinese authorities undertook the difficult decision to lockdown, putting the economy into a coma. As the Chinese population was highly compliant during the lockdown, the coma was short-lived, allowing the Chinese economy to stage a V-shaped rebound. China ended 2020 as the only major economy with positive growth and was also one of the world’s best performing stock markets over the 12 month period.

In 2021, we expect calmer waters as the economy returns to normalcy. Biden’s presidency will moderate US-China tensions in the near-term as more “conventional” diplomacy is restored, thereby reducing the tail risk of dramatic conflict. China’s GDP growth is likely to accelerate to 8%-9% this year, helped by a low base and increasing business and consumer confidence as the vaccine is rolled out. Importantly, the quality of growth will improve, as consumer spending and private sector investment replace manufacturing and the public sector as the key drivers of future growth. We believe fiscal and monetary policy will remain accommodative though will gradually normalise in line with the economic recovery. Interestingly, the relative austerity of China’s policy response during the pandemic meant that its long-criticized debt levels now look much more palatable in a global context. Overall, China entered 2021 as the only major economy with fully recovered economic activity levels, non-zero bound interest rates and a burnished reputation for the way that it handled the pandemic.

Structural positives

There are several longer-term structural positives whose impact will be felt beyond 2021. While the growth of the Chinese consumer class is well-known, its significance remains underappreciated in our view. It is estimated there will be 1.2 billion middle-class Chinese by 2027, accounting for one-quarter of the global total. New products, new channels, and new (increasingly domestic) brands are emerging to serve this demand. The manufacturing sector, where technology is fervently used to move up the ladder of advanced manufacturing, is being boosted by China’s wealth of talent in R&D. Finally, we believe China will shoulder more responsibility on global issues such as climate change. As the largest global emitter of greenhouse gases, China has ambitiously committed to peak its carbon emissions by 2030, and reach carbon neutrality by 2060. These structural positives will drive secular tailwinds in multiple sectors, and a handful of long-term winners are emerging.

Chinese equities

Like our economic outlook, we are broadly constructive on Chinese equities. Long-term valuations are reasonable with the total market capitalization standing at c.70% of China’s GDP in 2020, well below the global average. Chinese equities are chronically under-represented in global portfolios (3% of global fund allocation), despite China’s 16% share of global GDP. Chinese authorities are keen to liberalise the stock market, attract and breed high-quality new economy companies, and build investors’ confidence through regulation that protects minority shareholders. We believe large sections of the market in the small and mid-cap space remain undiscovered, and offer more compelling opportunities than the mega caps. To tap into those sections, we remain bottom-up driven and selective, maintaining a robust risk control framework based on company fundamentals.

In terms of risk to our outlook, a second Covid-19 wave is still possible despite the vaccine. Domestically, overtightening on monetary and fiscal policy could disrupt the economic recovery, although authorities are likely aware of the recovery’s fragility. Externally, inflation pressure or withdrawal of liquidity in a global context could spill over to China. Furthermore, despite many investors cheering Joe Biden’s US election victory, we believe that the US and China will remain in a great power competition for many years to come, albeit with some short-term reprieve. Investors should also be wary of certain swathes of the market that are very crowded at high valuations, and could see a sharp reversal in the short-term. One example is the internet sector, which is currently feeling the effects of recently drafted anti-monopoly regulation after years of very strong returns.

To conclude, we believe China’s economic growth will accelerate in 2021 as it continues on the recovery path whilst the longer-term tailwind of economic rebalancing will improve the quality of growth. As an asset class, Chinese equities offer exciting growth opportunities and strategic value to global investors.  The winning formula remains unchanged for us – a long-term focus, intensive bottom-up research on companies adopting stringent quality and ESG standards, and a strong valuation discipline.

Professional Paraplanner