Transcript
ANNOUNCER: TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management.
NAOUM TABET: Today's podcast is about Chinese equities, I think it's an interesting topic. You know, China is such a big market, it's too big to ignore. But I also want to understand that there are risks and opportunities that come by investing in that market. My name is Noaum Tabet, Managing Director and lead institutional CPM at TDAM. With me today is Karen Ko, Vice President, Director of TDAM and a specialist in international equities with specific expertise in the Chinese market.
NAOUM TABET: Thanks for joining me today, Karen.
KAREN KO: Thanks, Naoum, Glad to be here.
NAOUM TABET: My pleasure. Before we get into it and how to invest in the Chinese market, I want your thoughts around the geopolitical challenges that China is facing today.
KAREN KO: Absolutely. Geopolitical tension between China and U.S. is front and center on a lot of investors mind. I think what we have to recognize is that we are living in a new era of geopolitical relationships among the superpowers of the world, and that is U.S. and China. We have to get used to the ebb and flow of headline risk.
KAREN KO: And it also means that we probably have to approach risk management differently. So the U.S. and China are adjusting to a new paradigm of competition. They are trying to avoid conflict and confrontation. But on the other hand, learning to compete and live with each other. So since the COVID reopening, we have seen presidency has been pretty busy with its diplomatic efforts and we have also seen recent visits by the French, German and Brazilian head of state.
KAREN KO: So that's encouraging that China is still open for business. On the other hand, President Biden also said at the State of the Union address earlier this year that U.S. seeks competition, not conflicts. So China and U.S. are just too big and too important, mutually and to the global economy to be able to completely decouple from each other. So we should expect cooperation on global issues like climate change.
KAREN KO: But on the other hand, competition on other subjects like technology. And China is really well aware of the impact of trade sanctions. So the government has been adopting policy to really support and encourage R&D and innovation in key strategic industries.
NAOUM TABET: You know, you mentioned strategic industries. I'd like to get into that maybe a little bit later. But for now, like what resonates with me is that the Chinese market and the U.S. market, they're both so big and so important for each other that they have to avoid conflict and confrontation. And that's an important point to highlight, because from a geopolitical perspective, they can't really stress each other too much.
So hence, they both have to learn how to coexist. On the topic of strategic industries. You know, one thing that comes to mind is those state-owned enterprises, you know, called SOEs that term state owned. It doesn't bring a lot of comfort to investors. Can you explain what they are?
KAREN KO: Yeah. So it sounds pretty scary. So there's a myth that China is really dominated by SOE, and then this enterprises are less well managed than their POE, which is privately owned enterprises. Well, that's not entirely true, because if you look at the Shanghai and the Shenzhen stock markets, which are the two major stock exchanges in China, the number of listed companies POEs actually outnumber SOEs by two times.
And if you look at a lot of the metrics like profitability, leverage and ESG. So you sometimes are on par and in some cases even better than their counterparts. But it is true that board oversight remains the largest detractor. They have concentrated and controlling shareholders, and the board could operate in a pretty opaque manner. So to address that, the Chinese government State Council recently issued a new directive on independent directors.
And so we should expect that governance topic to improve over time.
NAOUM TABET: Okay. Thanks, Karen, for this overview of that. SOE structure, which is, you know, somewhat unique to China. Maybe I could take a different approach or maybe a different line of questions here. So for me, China and the story about investing in China is that of population growth and that population growth story was not something that we talked about,
You know, decades ago. As the population grows, you know, you got that movement from, you know, farming to industrial. You got the size of the middle class growing. Obviously, you know, population getting wealthier, wealthier population consumes more, which really translates into more growth. But with looking at China today, what I realize is that China's population growth is declining.
And you know, that that wealth effect seems to, not translate into possible future growth because that middle class is not growing beyond to what it is. Maybe I'm wrong, but maybe you could give me an overview on, you know, how will that impact future growth in China if that population growth is on the decline.
KAREN KO: No doubt GDP growth in China over the last few decades have been driven by population growth and also the emergence of the middle class. It really has been a volatile story because China has a big population, 1.4 billion, as of the latest census released in December 22, it point to a contracting population, the first decline in many decades. And also China's population growth rate has lowered tremendously and is now more aligned with our developed market and have a very fast aging population as well.
But GDP growth does not need to follow slowing population growth. The Chinese government has been very keenly focusing on education and innovation, and that can continue to drive productivity and also rise in GDP per capita and income will continue to support growth. Naoum, did you know that there are 240 million people in China who have a college degree and these are very sophisticated consumers?
So going forward, Chinese growth is going to be driven by quality and less by volume. These Chinese consumers are very sophisticated and demanding and they are going to demand better quality and premium products, hence consumption upgrade. And also, China has the lowest retirement age. You and I probably want to move there because women can retire at 55 and men at 60. Reforms are not tabled yet, but definitely could delay retirement if needed.
NAOUM TABET: You know, you talk about 240 million people with college degrees. I think the US is about 40 to 50 million people with college degrees - it’s just a massive amount of people that are educated, that are entering the workforce, that are actually producing and creating for the Chinese economy. And also, you know, I wouldn't say no for that retirement at 60.
NAOUM TABET: You know, I would love to retire in a few years. Why not? It's actually unbelievable to a point that people could retire so young in China. But what I would say, if China ever faces economic challenges, you know, this could change. Like you said earlier, reforms could delay retirement. Recession is top of mind for almost everybody I speak to and the Chinese enterprises like those SOEs or the private own enterprises in China, are they facing similar headwinds like the U.S. and Canada, for that matter, will be facing?
And that recession risk, where is it in China?
KAREN KO: So there has been a lot of headwinds in China. You mentioned geopolitical like in attention earlier, COVID lockdowns and also regulatory crackdown in e-commerce, education and real estate sectors. In 2023, these headwinds are actually turning into tailwinds. We already have seen foreign investors putting money to work in the Chinese equities market. If you look at the data through to Hong Kong stock on that program, January inflow was the highest in it’s history.
And in the first four months of this year, more than 26 billion U.S. dollars have already gone in. So part of that is people are constructive on the economic recovery in China. So the National People's Congress being held early in March, set the GDP target for 5%, I think that's perhaps a little bit like an under-promise, but they definitely have overdelivered so far.
First quarter GDP was four and a half percent, and that's above consensus and is led by consumption. So millions of Chinese people just wrapped up their first holiday, the Labor Day Golden week, where there was no COVID restriction at all in the last three years. And real data is very encouraging. Domestic tourism trips and revenue have already surpassed levels of the same holiday back in 2019.
Domestic travel is benefiting from reduced international flight and tourist visa’s to some degree, but on the other hand, the Chinese government really has tried to encourage domestic consumption by promoting cultural trips within the country and also they have reduced import tariffs and also established duty free travel destination in a few key cities in China as part of that, the circulation policy.
NAOUM TABET: So, you know, you talked about economic recovery. Things look good. China is actually entering a situation of tailwind, you know, contrary to a lot of, you know, the Western world or developed economies. But what about inflation? Isn't China also facing inflationary pressures like most of the world is? And also, if there's that pressure of inflation, where are interest rates going in China?
Maybe you could talk about monetary policy a little bit.
KAREN KO: Absolutely. So there has been no inflation or very little signs of inflation in China, and the monetary policy hence has been fairly stable. So the PBOC, which is the People's Bank of China, really has avoided aggressively cutting interest rates during COVID and hence coming out. On the other hand, they don't have to raise interest rate and there has been low inflation, as mentioned earlier.
So there really is no need to raise interest rate to fight inflation. And that is in contrary to a lot of the central banks we have seen in the developed market who have raised interest rates very aggressively in the last 12 months. So that has led to higher borrowing costs and hence higher equity premiums as well. And we have seen the IPO market in the US really dry up.
So China actually became the largest IPO market in 2022 globally and that actually present like, you know, new investment opportunities for investors.
NAOUM TABET: I really like it when you tell me that China is going through an economic recovery while the rest of the world is struggling. It does really seem like China could be a good diversifier to an equity portfolio. Now, most people maybe don't allocate from a diversification perspective only there's many ways to diversify. But I'd like to get a sense from you that if we allocate capital to Chinese stock, is it a good time?
What about valuation?
KAREN KO: Yes, we do think that 2023 we are quite constructive on China equity. Valuation is fair, but we think that corporate earnings are actually recovering. And this is again in contradiction or in contrary to a lot of the developed market where we actually see corporate profit margin plateauing and hence corporate earnings in ‘23 for developed markets could be disappointing.
And then longer term, if you look at why bother about investing in China, a lot of those long-term benefits still hold. You are still investing in China because the country is still enjoying secular growth. So National People's Congress in March put a lot of emphasis on technological innovation and self-sufficiency. We mentioned that earlier. This is to some degree in response to the sanctions and the competition on technology.
In fact, China has caught up with Europe in R&D spend, and will likely continue to provide supportive government policy to encourage innovation. China is rightly home to the second largest unicorn market behind a U.S. and unicorns, a breeding ground for future innovation leaders and many global leading companies, especially in renewable energy like wind turbines and solar panels and all the components that go into it,
already, a lot of Chinese company are leading. and China already produces very competitive electric vehicles as well. It is actually the largest and fastest growing EV market globally. They have an EV battery producer that has a leading technology and has the highest market share and is already supplying OEMs like Tesla, BMW and Volkswagen. We spoke about consumption earlier.
The Chinese middle class has ballooned over the last three decades and has changed the way the world produces and consumes and as I mentioned earlier, the continued growth in GDP per capita will continue to drive consumption and the government's policy of common prosperity. We would likely benefit lower taxes and create domestic champions as well. Like the Baijiu sector in China.
So this is China premium liquor with up to 65% alcohol by volume. Naoum have you ever tried it?
NAOUM TABET: No, but cheers to Baijiu at 65%.
KAREN KO: Yeah. I would have sent you a case, but unfortunately, they are out of stock in Canada. So the Chinese culture is really big on Muse and Banquet and celebrating festivals and significant life events with Baijiu. So again, like in all these opportunities, that is now available to foreign investors.
NAOUM TABET: So Karen I just want to touch on you know you talk about the Chinese stock market - how big is that stock market? Is there a lot of securities in there to pick from and create a diversified portfolio?
KAREN KO: So combining Shanghai and Shenzhen, there are more than 4600 listed companies. So that's a pretty big market. So if you look at Shenzhen and Shanghai combined, there are 4600 companies listed on the on the stock exchanges there. And if you look at the global market cap, U.S. is still the largest at 41% of the global equity market cap, but China is second at 12%.
And if you measure against our global economy the size of the GDP, U.S. is still the largest at 24% and China is the second largest at 16%. So for investors who think that they could get exposure to China by just investing in one global equity strategy, then you are probably underrepresented because despite China being the second largest economy, it's weight in
the equity index is only 4% and the US is actually at 60%. So hence we do think that for investors who want to take advantage of the full availability of opportunities in China, having a dedicated China exposure and allocation is the way to go. And also if you look at China a-shares, they have a low correlation of return to the rest of the global equity market and low correlation is an important factor for risk diversification because the market returns move independently of each other.
And we have seen more recently the economic cycle and the monetary policy cycle seems to be more a synchronized as well, and hence the diversification benefit holds even better these days.
NAOUM TABET: Yeah, you made a good point earlier. You know about inflation. China is not faced with a recession. China is at a different stage in its economic cycle, which really clarified the diversification benefits. But you mentioned A-shares. Can you clarify what these a-shares are?
KAREN KO: Absolutely. I think it could be pretty confusing for investors looking at China for the first time and here A, B, H and N is almost like an alphabet soup. So broadly speaking, you could classify Chinese equities into the onshore and the offshore channel. So the onshore channels are the A-shares. So these are Chinese companies listed on the Shanghai or Shenzhen Stock Exchange.
So for foreign investors who want to buy directly to A-shares, you do have to be classified yourself or qualify yourself as a QFII - so that would be qualified for institutional investors or you buy through the Hong Kong Stock Connect program and then the offshore market are Chinese companies listed outside of China. So most of them would be the H shares in Hong Kong or the ADR shares in the U.S.
Naoum, I'm sure you have heard of Alibaba or Tencent. So these are more household names, more well known, and these companies are listed overseas. But if you look at what is really overlapping between the A and the H, there are only a handful of companies who are dually listed. So they do offer a very different opportunity set like the Baijiu sector I mentioned earlier, they are only in the A shares.
So if you look at the last decade, the fastest growing strategies are China A onshore strategies. The number of strategies as well as the AUM have more than doubled between 2012 and 2022. Also, when it comes to investing in China, we do think that adopting an active approach makes sense because the China A onshore market is still inefficient. So there is less sell side broker coverage.
And also if you look at the daily trading volume is still dominated by retail investors. So active management does provide the opportunity to take advantage of the inefficiency and indeed they have because active management has consistently produced better returns at benchmark.
NAOUM TABET: So that can summarize everything you said so far today in this podcast is that the Chinese market is very large, very diverse, many ways to access it. A share market is probably the most effective way to access that market from a valuation perspective looks good from a short and long term perspective from a correlation perspective makes a lot of sense. A lot of good information. Thank you so much for joining me today. If you want to learn more about investing in China, please reach out to your relationship manager who could arrange a call with Karen to have a further discussion. Thank you.
Disclaimer
ANNOUNCER:
The information contained herein has been provided by TD Asset Management and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax, or investment advice. Particular investment tax or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.
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