‘Invert, always invert: Turn a situation or problem upside down. Look at it backward.’
– Charlie Munger
’Three great mountains that need to be overcome by the revolutionary forces: imperialism, feudalism and crony capitalism.’
Following the sage advice of Charlie Munger, instead of trying to answer the question ’Is it time to be constructive on China?’ we will invert the question and address it backwards. What are the challenges that may derail a potential bull run? To paraphrase Mao, there are “two great mountains and a long hill” facing the Chinese economy and financial market: opaque technology regulations and geopolitics are the two great mountains and the exit from Covid the long hill. Let us assess them one by one.
Technology regulation, business confidence and the red carpet
There was recently a tweet on FinTwit that encapsulates the growth philosophies of the three largest economies well: “China – innovate then regulate; Europe – regulate then not innovate; US – innovate then not regulate”. In previous articles, we explained that as the consumer internet industry graduates from adolescence to adulthood, many of the technology regulations we saw in China are not only justified but also long overdue.
Nevertheless, the speed and scope of these regulations, and the haphazard style in which they were rolled out with limited communication and coordination – even between different government agencies – have significantly undermined business confidence. The damage is done, so what can they do about it and will they? The answers are ‘plenty’ and ‘yes’.
The first green shoots occurred in October 2021, as we noticed subtle but clear changes in state media narrative, moving away from constant tech bashing to one acknowledging the industry’s importance in driving innovation and growth. Since then, it has been encouraging to observe policy developments that are consistent with its goal to address market concerns and restore business confidence, with ever higher cadence, urgency and more substance.
Eighteen months after the beginning of the regulation tightening cycle, the policy pendulum has started to swing back to pro-growth and pro-business. Policymakers are saying and willing to do all they can to restore market confidence. The red carpet for entrepreneurs, businesses and investors is rolling out once again.
Subtle but clear change in policy narrative from constant technology bashing to one acknowledging its importance in driving innovation and growth
Politburo meeting; dropped regulation from 2022 priorities and growth pivot
Vice Premier Liu He ‘policy put’ meeting:
• Complete the rectification work of large platform companies as soon as possible
• Regulation should be transparent and predictable
• (The government) will promote the development of platform companies
Politburo meeting; President Xi explicitly said he supports technology platforms to support economic growth
Tech Symposium hosted by top political advisory body, attended by key executives from the industry and two Vice Premiers
Source: Polar Capital.
Mercantilism trumps ideology
Since the Russia/Ukraine war broke out, the perception of China’s geopolitical risk has escalated materially. Many investors are worried about secondary sanctions and Taiwan. We think it is a misguided perception. As Charlie Munger often advised: “Show me the incentives and I will show you the outcome”. It is through the lens of incentives that we believe that risk is very low and manageable. Let us begin by establishing a few facts:
- Mercantilism is at the core of the Chinese system. If anything remotely resembles state religion in China now, it is mercantilism. With buy-ins from almost every corner of the country and all walks of life, from politicians to plumbers, from entrepreneurs to engineers, from coders to chefs, from cosmopolitan Shanghai to far-flung villages in the rust belt north-east, all stakeholders have the deeply embedded conviction that if they can trade and transact freely and easily with others, foreign and domestic, all will be better. A small group of nostalgic Maoists are not able to dismantle this. Even at the peak of China/US trade war in late 2018 with Tesla teetering on the financial brink, the Shanghai government decided to subsidise Tesla’s new Gigafactory instead of a local challenger Nio, because they viewed Tesla better placed to promote the development of a strong electric vehicle supply chain ecosystem.
- The US has significantly more economic ties and interests with China than Russia. Both in trade and investment, China is considerably more important to the US by orders of magnitude. Sanctioning Russia is a relatively painless decision; sanctioning China will be far more problematic and costly.
Total trade in goods with
Trading partners ranking
Direct Investment in
Source: ITC Trade Map, Central Bank of Russia, OECD, US Congress.
- Ukraine invasion forced hawks in China to update their cost/benefit analysis. A drawn-out war, a closer transatlantic alliance and the swiftness and severity of sanctions have forced the hawks to recalculate, costs have gone up, risk has shot up and predictability has dropped.
On the China side, the war in Ukraine, by providing real world data to hawks, has significantly increased the cost and risk of an alliance with Russia and invading Taiwan. At the same time, its deeply rooted mercantile instinct is fighting back and recalibrating the country’s priorities towards economic growth and de-escalating tensions. On the US side, in absence of overt Chinese support for Russia, secondary sanctions are not only difficult to justify but also exorbitantly costly.
The geopolitical tension and strategic rivalry between China and the US will persist for decades to come. In our opinion, instead of escalating the tension the Russia/Ukraine war has made geopolitical risk lower and more manageable in the medium term. Rather than thinking geopolitical risk in China is too high to invest, investors should ask: “Is the risk/reward attractive enough now to justify the low level of geopolitical risk?”.
Protracted exit from Covid
The bungled lockdown in Shanghai was the unfortunate result of China’s draconian yet very effective Covid policy of track and trace, mass testing and precision lockdowns in the previous two years. It had served consumers and global supply chains well as the country had been mostly Covid-free for two years. Except this time we are dealing with a variant that behaves very differently. They have a brilliant hammer and see every variant as a nail.
Since mid-April, Covid policies have started to respond to the new variant and reality. Shanghai passed the peak of the current Omicron wave in early May and has been in the process of reopening since 1 June. The worst is over and both consumer demand and the supply chain are eager to return to normal soon.
China’s new toolbox of what I call ‘light Covid zero’ can now deal with highly transmissible new variants well. However, ‘light Covid zero’ is likely to stay for a while as policymakers still do not yet seem prepared to live with Covid. Therefore, consumer demand will likely run below its full potential until much later this year.
Peak Omicron is behind us. Both supply and demand are in recovery mode.
The path of least resistance
Markets, like water, tend to follow the path of least resistance. Among the three key challenges facing the China market, regulation risk has been addressed earnestly by policymakers and we believe the regulation cycle is over; geopolitical risk is now materially lower and manageable because of the Russia/Ukraine war and hawks are losing influence domestically; Covid risk will linger for a little longer, but the worst is over as Shanghai starts its reopening process.
In addition, responding to rising external and internal macro challenges, government policy stimulus, both fiscal and monetary, is going to be materially bigger. This combines well with rock bottom company valuations we are seeing across our portfolio of high-quality companies with high structural growth. We cannot help but believe this is one of the best times to be constructive on China equity.