Baba Stock – Why the service sector holds the key to China’s recovery
John Leiper of Tavistock Wealth
The narrative of 2020 equity market losers becoming 2021 winners has played out so far this year with the rotation out of growth stocks and into value and more cyclical parts of the market.
This theme is also evidenced by China’s notable reversal of fortunes. Since mid-February, the CSI 300 index of Shanghai- and Shenzhen-listed stocks has fallen 12%, three times the MSCI Emerging Market index which has lost 4% over the same period. That is a far cry from the 50% absolute/20% relative return achieved over the prior 12-month rolling period.
This pivot can be attributed to several factors. First and foremost China is at a different point of the economic cycle. Having handled the pandemic far better than many of its peers, policymakers are now normalising monetary policy at a faster rate than elsewhere, sapping liquidity from markets.
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In addition, the recent regulatory crackdown on China’s domestic tech giants, such as Jack Ma’s Ant Group and Alibaba, has weighed on investor sentiment.
This has been compounded by a technical event, catalysed by the hedge fund Archegos Capital Management, which led to additional selling pressure of Chinese internet companies following a margin call on its long position in ViacomCBS.
However, there are growing signs the tide may be about to turn. As shown in the chart below, there is a clear inverse relationship between the MSCI China and MSCI Emerging Markets Ex-China indices, which tends to move in cycles and does so with remarkable symmetry over time.
If historical correlations hold true, the relative performance of Chinese equities to emerging markets in general may be about to bottom and could rebound and outperform going forward.
China’s GDP soared 18.3% in Q1, from a very low base one year prior, and an increasing number of analysts remain bullish for the country’s prospects over the rest of 2021.
China’s recovery is on track, but consumption remains in the spotlight
Against that positive background, we think recent volatility may have created an attractive entry point. Our preferred way to play this theme is via Chinese technology companies, which comprise the bulk of the MSCI China index.
Recent Q4 earnings for companies such as Tencent and Pinduoduo have come in strong, suggesting the shift to online spending has continued even as the pandemic has receded.
This is consistent with the People’s Bank of China’s supposed strategic direction given recent pilot programs trialling the digital RMB, or eCNY, across several domestic cities.
Indeed, it is telling that a number of internet firms, such as Ant’s MYbank and Tencent’s WeBank, have participated in the roll-out of these programmes.
While the recent regulatory action remains a cause for concern and we could see additional fines hit the sector, like that imposed on Alibaba, much of the bad news may already be priced in. In fact, Alibaba shares rebounded strongly following the announcement of said fine.
Moreover, ongoing regulatory impact could prove muted as US-China technological and geopolitical rivalry continues to escalate.
Finally, we think investors could also benefit from a potential currency tailwind. As the US ramps up public spending, Beijing’s relative fiscal prudence could prove renminbi-bullish, contributing to a rise in Asian currencies more broadly.
Bottom line, a continuation of the growth-value rotation will continue to hurt technology stocks. However, unlike US mega-cap tech stocks, we see further upside in countries such as China whose economy continues to transition from an industrial export-led model towards services.
This growth in the service sector economy should re-accelerate towards its prior trend as the coronavirus recedes into the background, driven by growing domestic consumption via the well-known impact of ongoing rural-to urban migration and rising internet penetration rates, which offer significant upside potential versus the saturated levels of many developed market peers.
John Leiper is chief investment officer at Tavistock Wealth