Throughout his two-decade career, Ernest Yeung has seen at least six downturns in the Chinese market.
Like him, many others are no strangers to China’s cycles, says Yeung. But those who have focused their attention primarily on the US — where stocks enjoyed a steady upward trend over the past decade — have forgotten about economic cycles, he says.
“We have to keep in mind when investing in China and the emerging markets that there have always been cycles. Whenever cycles go down, people tend to expect really, really bad things. At that point, sometimes we need to be contrarian and we need to be ready to buy,” says the portfolio manager for the emerging markets discovery equity strategy at T Rowe Price.
Speaking at the American investment management firm’s Mid-Year Market Outlook webinar on June 15, Yeung raises another hypothesis: China’s stock market is driven by the world’s investments into it, and less by the blessings or crackdowns from its central government.
“Although we do spend a lot of time talking about China’s regulations, a large part of the Chinese stock market is driven by international factors, not just politics and regulation,” says Yeung, who is based in Hong Kong.
See also: Unveiling value opportunities in energy, healthcare and technology
Just like US tech names Amazon and Meta (formerly Facebook), Tencent and Alibaba were the biggest Chinese stocks, too, says Yeung. “The index compositions were the same.”
That said, Yeung points out that China has many different — and at times, conflicting — objectives to balance. They broadly fall into two categories: social harmony and macroeconomic growth. “Now, the sad thing for market participants is that in the past two, three years, we’ve pushed a lot towards social harmony by restoring balance and equality in the country. But the policies did not focus much on the macro[economic growth] side. That’s why the stock and bond markets took a big hit.”
Drawing on the cycles Yeung has seen in his career, he believes Beijing is beginning to pivot back towards emphasising growth. “The key is to keep more than 1 billion people happy. [That includes] GDP growth, job creation [and] investments in the industry. That’s why, in the past two, three months, we’ve started to hear and see potential reversion on Internet and property [sector] regulations.”
See also: Time to rethink traditional thinking in emerging markets
Don’t forget China’s ‘boring sectors’
From 2000 to 2010, China overinvested — leading to a massive increase in manufacturing capacities, property development and infrastructure construction. This has resulted in an oversupply situation seen in many of these sectors.
From 2000 to 2021, the capex to depreciation ratio fell below the maintenance rate of a dollar for China’s airlines, industrials and old, gas and consumable fuels, says Yeung.
How does this affect the markets today? Some sectors in the US are experiencing high inflation, such as hospital services, college tuition and childcare, notes Yeung. These are mostly services that cannot possibly be outsourced beyond the country.
However, prices for other goods, like clothes, toys, computers and television sets, have become more affordable between 2000 and 2021. “Offsetting [the prices of] all the tradable goods: your jeans, your shoes, your smartphone; there’s one reason why those prices have not been going up — because they are made in Asia; they are made in China,” says Yeung.
In short, they all benefit from China’s over-investment in the immediate post-Y2K period, he adds.
You can keep your [investments in] EV [electric vehicles], you can keep your solar, you can keep your wind; but don’t ignore the more boring parts of the market — the old economy part of the market — because there are significant shortages there, such as auto parts, banks and materials.
For more stories about where money flows, click here for Capital Section
However, President Xi Jinping, who was appointed in 2011, changed the trajectory of China’s investments, shifting away from “old economy” sectors like industrials and auto components, adds Yeung.
With the investment commitment to other sectors, the overcapacity began to be digested. “So, I would suggest that the tradable sectors may be slowly moving up as well, as China stops exporting deflation,” says Yeung.
Hence, Yeung suggests a contrarian approach. “You can keep your [investments in] EV [electric vehicles], you can keep your solar, you can keep your wind; but don’t ignore the more boring parts of the market — the old economy part of the market — because there are significant shortages there, such as auto parts, banks and materials.”
These examples can even aid in the green transition, says Yeung, from securing bank loans to building factories and mining copper and aluminium for renewable energy projects.
Recession least likely in Asia While Asia runs the risk of a recession in the coming months, the likelihood of a downturn here is lower than that of virtually every other region.
This could be thanks to the “softening and loosening” of monetary policy in China, says Thomas Poullaouec, head of multi-asset solutions, Asia Pacific, in the multi-asset division of T Rowe Price.
“I would say the risks of a recession in Asia are definitely there, but perhaps lower than they are in other emerging market regions, and even in some developed market regions like Europe and the US, which are facing this inflationary pressure that will be tackled by the central banks,” he says.
Poullaouec says the fast-rising inflation in the US will slow in the coming months, but it will reset at a higher level “than we were used to”. “Some people are talking about 10% inflation in the US. This is not our base case, but it definitely is a risk to the upside,” says Poullaouec, who is based in Singapore.
Amid inflationary headwinds and the rising rates meant to counter them, Poullaouec advises investors not to “fight the Fed”. “What matters here is not necessarily what you believe the Fed should do, but trying to understand what the Fed is looking at in order to make its decision,” he says.
As “traditional diversifiers” like government bonds start to pale in returns, investors are on the lookout for safe haven assets to balance their equity holdings, says Poullaouec.
Amid this flight to safety, however, he reminds investors to temper their expectations, as yields are moderating from a high base. “We come from a period where valuations were quite elevated, especially when we think about the evolution of the real yield in the US.”
Emerging markets bottoming out
What matters for investors is not necessarily the absolute level of earnings growth but its trajectory, says Poullaouec.
Looking at the big picture, emerging market equities have likely troughed, he adds. “What we like about emerging markets is that we might have already found the bottom in terms of earnings expectations this year; they are expected to rebound in 2023.”
In comparison, expectations in the other markets “might still be too optimistic”, he says. “We might see earnings growth being revised downwards as we see the economic slowdown as perhaps more pronounced in developed markets.”
Poullaouec recommends a “modernised 60/40 approach” for investors. For years, the mainstay portfolio of most investors is to allocate 60% to equities for a reasonable chance, albeit with risks, to capture a decent upside, and 40% allocated to bonds for the certainty of a yield.
He now suggests investors allocate 29% of their portfolio to large-cap global equities, with a mix of growth and value stocks; and 10% to risk-mitigated large-caps.
He also recommends a 9% allocation to small-cap equities and just 4% to emerging market stocks. “An equity portfolio with a risk overlay will protect your portfolio through derivative positions that can be in options or futures to protect the portfolio when volatility increases,” he says.
He recommends investors allocate 12% each to bonds and liquid alternatives or absolute return. “This doesn’t always have to be hedge funds, but if you have strategies in fixed income, that can be an absolute return.”
Across assets, T Rowe Price is adopting a cautious stance for the latter half of the year. “We are underweight equity and overweight fixed income, but that means overweight cash and absolute return on cash as well,” says Poullaouec.
“Within regions, we favour emerging markets. Compared to the other regions, we are still overweight value over growth [stocks] as well as small-cap over large-cap.”
He adds: “We have a neutral stance on real asset equity; we move that from underweight to overweight throughout the year to reposition our portfolio in that inflationary environment.”
Photos and infographics: T Rowe Price