Key Takeaways
- Our outlook for China in 2022 is constructive. After a year of significant policy changes, we believe that industry participants and investors have recognized the government’s strategic aims and are adapting to the new regulatory frameworks.
- China’s easing monetary policy, seen against a tightening bias in the West, could also strengthen the investment case for both Chinese equities and stocks in the broader emerging market universe.
- We expect quality companies in China to deliver growth across market cycles. We also see growth opportunities for companies that are likely to benefit from policy tailwinds.
Policy Recalibration in Progress
2021 marked a year of significant policy changes in China. “Common prosperity,” which had long been an underlying theme in the economy, rose to the forefront and set the context for regulators looking to address imbalances within the internet, education, property and other industries. On a broader level, the government displayed its willingness to trade off sharp economic growth for quality and sustainable growth. The policy shifts, coming on top of a restrictive monetary and fiscal stance, created market volatility as investors reset their expectations.
Entering 2022, our outlook for China is constructive. We believe that industry participants and investors have recognized the government’s strategic aims and are adapting to the new regulatory frameworks. We could also start to see an incremental normalization in regulatory actions. Take the internet industry as an example. The government showed that it was uncomfortable with the concentration of market power in a few large companies and laid out broad requirements to level the playing field. Importantly, it still understood these companies’ virtues in terms of generating business opportunities for their users, which ultimately supports common prosperity. The antitrust penalties that the authorities have imposed and the corrective steps that companies have undertaken indicate good progress for the industry in emerging from regulatory scrutiny.
Internet companies have been adjusting their business models in light of the new socioeconomic order, which has weighed on their earnings growth and stock valuations. Nonetheless, we are hopeful that they can resume their earnings momentum when the regulatory dust settles and their new business models take shape, perhaps toward the second half of 2022. The steep declines in their valuation multiples are a sign that investors have priced in much of the concern surrounding their future earnings.
Markets have been nervous about regulators turning their sights to health care, one of the “three big mountains”—along with housing and education—driving up living costs in China. In our view, such worries overlook the major reforms that officials have already introduced in the past few years to improve drug affordability and quality for an aging population. The National Reimbursement Drug List1 and Volume-Based Procurement program,2 for example, have helped to lower drug prices. The government is also encouraging the development of first-in-class or best-in-class treatments in China, and we have seen local biotechnology firms succeed with innovative oncology drugs that have secured regulatory approvals and licensing deals in the West.
As a whole, we believe the most extensive policy changes could be largely behind us. These changes could give rise to micro regulations down the line, although we expect the latter to have less impact on markets. That said, we would not rule out future regulatory crackdowns completely. Industries that begin to see market concentration risk, excessive capital inflows or other imbalances are likely to draw regulators’ attention. This highlights the realities of investing in China, a market that we think is more policy-driven than economy-driven.
Easing Monetary Stance
Meanwhile, China has started to loosen its monetary policy. Its easing stance, seen against a tightening bias in the West to counter inflation, could strengthen the investment case for Chinese equities and broader emerging market stocks. Although rising inflation is a global phenomenon and producer prices in China have climbed, Chinese producers’ margins have been more resilient than we expected, signaling their ability to pass on some cost increases to end-consumers locally and overseas. This partly reflects the world’s continued dependence on China for a wide range of goods in the absence of alternative sources of supply. We expect global inflationary pressures to recede in 2022, though not to previous lows. The pandemic could continue to obstruct supply chains, while US trade tariffs and a general deterioration in global trade relations in recent years could underpin inflation structurally.
Our outlook for China comes with caveats, one of which is how the pandemic plays out. China has adopted a “zero-COVID-19” strategy, due in part to its large population and the sizeable health care costs that uncontrolled outbreaks would incur. We do not see China opening up meaningfully without a higher vaccination rate and proof that available vaccines would be effective against any coronavirus variant. The strict approach could also last at least until the Chinese Communist Party’s 20th National Congress in late 2022. We expect travel restrictions and other curbs to keep domestic consumption subdued.
In addition, geopolitical tensions between China and the United States are likely to remain. Although the tone of engagement under US President Joe Biden’s administration appears to have become more nuanced, we believe that the United States and other Western nations have largely come to view China as a growing economic and strategic rival.
Where We See Opportunities
For all the changes that could unfold in 2022, how we think about investing in China has stayed the same. We expect quality companies to deliver growth across market cycles. Even as China’s economic momentum moderates, we believe that select well-run businesses still have opportunities to outperform their competition, whether through market share gains or better cash flow and balance sheet management. Pricing power stands out to us as another aspect of quality, and businesses with that advantage often include services companies that have few input costs and manufacturers with distinct intellectual property. In short, we view quality companies as potential “serial compounders” that could emerge stronger regardless of market conditions.
We also see growth opportunities for companies that are likely to benefit from policy tailwinds. China’s push for quality economic development and a better living environment has helped the renewable energy and electric vehicle (EV) industries. We believe that China’s EV industry has crossed a tipping point, where consumers’ growing acceptance of EVs as their primary vehicles suggests that it may not need a lot more government support from here. In fact, we believe China may find it favorable to foster national champions in the EV and renewable energy industries that could go on to become global leaders. Already, several EV-related and solar energy companies in China have taken the top spots in global market share.
Our search for quality firms and companies on the right side of policy change requires us to continually investigate and analyze China’s economic, political, business and market landscapes. We expect this rigor to be no different from what we have been applying in all the years we have invested in China, and we are constructive about the potential investment opportunities ahead.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
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1. China’s national health insurance schemes cover drugs on the National Reimbursement Drug List. Drugmakers have agreed to reduce prices for their treatments to secure their inclusion in the list.
2. The Volume-Based Procurement program centralizes the purchases of drugs and medical devices in China and has helped to reduce their prices.
