China growth tremors signal return of emerging market risk premium, says Unigestion

China investment

Investors have had a “very loud reminder of the overall emerging market risk” after recent wobbles in China’s tech sector, says Unigestion’s head of Fundamental Research, Gaël Combes.

Fears grew over a broad-based crackdown on China’s tech sector after the government banned the recently-listed ride-hailing app Didi from app stores in July, over concerns about the firms’ storage of user data. The regulator has also threatened to wipe out China’s private education market with new regulations.

Nasdaq Golden Dragon China index, which tracks Chinese tech stocks listed in New York, fell 19 per cent towards the end of July, while shares in Tencent and Alibaba registered double-digit drops in price.

"Investors are like the passenger on the bus, and have very little control over where the driver wants to go. I think this is the main takeaway of the recent news flow,” says Combes, highlighting China’s tightening regulatory grip on markets.

According to Combes, the regulatory threat to investing in China comes from the government’s “ability to act” quickly, coupled with their “will to act”.

China’s moves to limit the power of big tech companies represent a “significant change” compared with the country’s former policies, and have only accelerated over the past year following high-profile regulatory action against Alibaba’s Ant Group.

China previously adopted a “very protective” stance, allowing firms like search engine giant Baidu to hold their dominant market position by preventing large foreign companies such as Google from entering the market. 

This reversal in policy has been “very negative for innovation”, says Combes, especially in contrast to the US environment.

“This brings up some key questions for the future, and the development of China when it comes to technology, the internet, and innovation, as obviously the Fintech area was a very innovative industry in China.” 

Companies such as Alibaba and Tencent were developing their own e-payment ecosystems, which conflicts with the government’s attempts to build a digital yuan. 

“If there is a digital yuan that they must use, [fintechs] will probably not be in a better position than the legacy banks, so they won't be able to really take as much market share or transform the sector as much as they'd expected to,” says Combes.

However, recent market movements have pushed up the pricing of risk, helping to improve the relative performance of Unigestion’s emerging market strategies.

“We've been falling at roughly half the market rate,” says Combes. This is largely because of Unigestion’s “significant underweights” in Tencent and Alibaba, two of the worst-hit Chinese tech companies, and also a “much lower” market beta. 

Unigestion has a bias toward defensive stocks, with particular exposure to the quality factor.

“The past few years have been very favourable to risky assets and it's been quite a tough environment for us, as the price of risk fell to a very low level,” says Combes. 

Investors have started reducing their emerging markets equity allocations due to fears of slower growth in China.

Allocations have fallen by 17 per cent to a net 14 per cent overweight, according to Bank of America’s monthly survey of fund managers in July. This is the lowest average overweight since October 2020.

“One thing that investors are trying to assess is whether this tremor in China will have some contagion effect,” says Combes. “If we start to see earnings revisions or lower growth for the mega caps, it means that they will contribute less to index growth, and overall that could lower equity earnings growth prospects in China.” 

In July, China’s PMI, often seen as a proxy for wider emerging market growth, fell by half a percentage point from the previous month, indicating slower company activity.

In addition, the MSCI Emerging Markets Index has wiped out its gains in 2021, while developed market stocks in the US and Europe have continued to rise. 

“I think it is likely to put upward pressure on the equity and emerging market risk premium,” says Combes. 

As for the future, Unigestion expects slower growth in China, which regulators have so far signalled they are comfortable with. “Now what we're watching for is when they reach a point where actually they start feeling uncomfortable, and we start an easing phase again, as China has done in the past. We think we're not there yet.” 

The Chinese government has clearly stated that it wants to continue to shift the economy towards more domestic consumption, which could mean that its contribution to global growth will become “probably less impactful than it used to be”. 

Unigestion’s macro indicators suggest that China is on a different path from Europe or the US, due to China being the first to rebound after the Covid crisis. Since Europe and the US took longer to emerge from the pandemic, they are in the middle of a strong re-opening bounce.

“Over the next two quarters, there’s probably no doubt that US and Europe will continue to lead,” says Combes. 

He continues: “The developed world is outpacing the emerging market world in the medium-long term.” Within emerging markets, Unigestion favours India and North Asian countries including South Korea and Taiwan, while expecting South Africa and Brazil to be hampered by ongoing structural challenges.
 

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Madeleine Taylor
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