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China Innovator Active ETF: Third-Quarter Review

The third quarter of 2021 featured unprecedented market regulation centered on internet platforms, which cooled market sentiment. Yet within months, we’ve observed that the regulatory overhang has already peaked on the back of lighter news flow. This can be attributed to two reasons—the initial batch of market regulation had addressed the social issues caused by internet platforms and impacted employment, while the property sector saw some downward pressure.

From a long-term perspective, we believe that Beijing’s regulatory crackdown during the summer of 2021 is likely to be followed by much lighter regulation in the coming years, as regulations speculated for the mid to long term have already been implemented. Despite the market backdrop, we still maintain a meaningful exposure to internet platform companies, though we have reduced it over the course of this uncertain period.

Overall Strategy

The MSCI China All Shares Index corrected substantially in light of the market regulations introduced over a short period. Our fund was similarly affected, especially from selling pressure on growth-style stocks. The healthcare sector became the main detractor, while electric vehicles and batteries and clean energy stocks were supportive.

Year to date, growth stocks underperformed against the MSCI China All Shares Index. That said, we are confident that China remains a fertile environment for high-growth stocks, particularly for those in clean energy, electric vehicles and batteries, smart grid, biotechnology, fintech, semiconductors and automation.

Despite investor concerns amid a deepening energy crisis and weakened property market in China, there are some positive developments that have emerged.

Regulatory Backdrop Sets the Scene for Xi Jinping’s Third Term

Regulatory uncertainty has historically been considered as a persistent bear for the China equity market by some market commentators. A combination of government influence and support for particular sectors resulted in some policy overhang. That said, the overall impact was largely manageable through portfolio diversification and the fact we were at different stages of the industry life cycle.

We are faced with questions as to why the latest round of regulatory announcements came within a short time frame. After years of supporting a high-growth economy, Chinese policymakers are now pivoting to social issues caused by anti-competitive behavior in a bid to pursue common prosperity. Yet this time, the political cycle may offer some explanation: Chinese President Xi Jinping is set to head into a third term in power, providing an ample runway to roll out populist policies that are in line with elevating the general population. While China has no direct electoral system to reflect the will of the people, the central government is often keen to win people’s support through these types of policies.

So, on the back of an unprecedented regulatory crackdown on domestic technology giants over the summer, we believe it will be followed by much lighter regulatory changes in the coming years—many policies were brought forward as part of a regulatory overhaul.

Evergrande Event Not Reflective of China

The events surrounding the Evergrande Group’s 2 trillion yuan (US$300 billion) cash shortage created a drag on markets in late September. Some considered the issues with China’s second-largest property developer as a reflection of the state of China’s real estate sector, filled with companies that held private debt or used wealth management product sales to fund operations—drawing comparisons to another “Lehman” event.

However, we see this issue in another light. The Evergrande situation should not be considered as part of a China-centric issue, but a unique case. Recall that Evergrande’s ascension to become one of the largest Chinese developers came about as other developers chose not to expand in the same way to stay in line with government guidelines on curbing leverage and had manageable balance sheets.

This policy guidance is particularly evident in the way Chinese banks have built up reserves over the last decade. In general, Chinese banks had much more prudent balance sheets compared to US investment banks during the subprime mortgage crisis. So, the potential default of Evergrande is unlikely trigger a financial contagion risk.

Chinese banks had built up massive loan loss reserves over last decade, as well as tier one core capital, typically used to fund business activities for bank clients. In the first half of 2020, Chinese banks’ exposure to Evergrande was around 0.24% of total lending, a manageable figure in addition to more than 3% of loan loss reserves and 200% non-performing loan coverage in balance sheets.1 By comparison, US and European banks now have less than 1% in loan loss reserve ratios on average.2 Meanwhile, leverage ratios in Chinese banks, as defined by assets to equity, look prudent at around 10 times that amount.3 With much-improved loan loss reserves, we think that China’s banking system is a world away from the 2008 global financial crisis.

That said, a potential Evergrande default would have a ripple impact on the whole economy. The real estate sector contributes around 20% to gross domestic product, but we expect other positive developments to offset this impact.4 First, corporate investments could be supportive of the economy thanks to strong export growth over the last 18 months.5 Secondly, the government could step in to boost infrastructure projects through fiscal spending and local government bond issuances.

Counterintuitively, sluggish property market conditions could in turn boost the equity market, as one is generally considered a substitute for the other in this market. China in general has a vast amount of domestic savings, yet more than half of household assets remain stuck in real estate.6 The Chinese government has shown a strong will to divert savings to more productive areas such as capital markets, yet this has yet to be fully achieved. However, with lower expectations on property price appreciation in light of the current backdrop, it could provide an incentive for households to consider moving assets into the equity market.

Power Shortage Provides Fuel for Thought

Since late September, some provinces have started rationing power, affecting everything from day-to-day life, energy-intensive industries and GDP growth.

We observe two elements that have contributed towards the energy crisis—first, a supply-demand mismatch in coal has heavily impacted domestic industries. Around 90% of the coal used in China is locally produced.7 Yet year to August, industrial production grew 14% year-over-year, while domestic coal production grew 4.4% year-on-year.8 A domestic shortfall in addition to geopolitical tensions with Australia, led to a ban on Australian thermal coal shipments, which is impacting those industries that are reliant on the fossil fuel.

Secondly, the Chinese government’s longstanding commitment to reducing carbon emissions has forced local governments to ration power so that each province can meet its carbon reduction quota before year end.

A power shortage creates uncertainty for the economy, but from a long term perspective it is a positive development as the world transitions towards clean energy. These trends will likely push the coal power tariff by up to 20% in China in the near term, and may become a tailwind for solar and wind power as these energy sources become more profitable, in our view. We think this gradual uptick in coal and gas power is unlikely to confined to China, and may become more widespread across the globe. In the same way, the latest increase in raw materials put a dent in solar sector volume growth and became a factor as to why solar panels were generally more expensive this year, the first time in the last decade.9

While we see encouraging developments within the solar, wind and smart grid industries, we are also particularly interested in battery-based energy-saving systems, which we’d expect to be in high demand as China tackles the current energy issue. Our multi-year outlook for the clean energy sector is encouraging, on the back of higher coal and gas tariffs, the world’s commitment towards reducing carbon emission and China’s dedication towards developing clean energy solutions. Overall, while we saw unprecedented market regulation, a credit event and a power shortage in China over the last quarter, we remain encouraged by the long-term prospects in China—backed by an exciting pipeline of developments we’ve observed with some innovative industry leaders.

Phil S. LEE
Head of AP Research

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1 Source: CLSA, 2021.
2 Source: Citi, 2021.
3 Source: CLSA, 2021.
4 Source: Caixin Insight, 2021.
5 Source: National Bureau of Statistics of China, September, 2021.
6 Source: The New York Times, October 21, 2021.
7 Source: Reuters, October 13, 2020.
8 Source: Caixin Insight, September 2021.
9 Source: Bloomberg, September 30, 2021.

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