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Federated Hermes: China’s future of moderate and sustainable growth

With multi-sector regulatory crackdown, Evergrande’s default and the energy crisis prompting the government to walk a tightrope between high emissions and power shortages, China has been under increased investor scrutiny. However, Kunjal Gala, Global Emerging Markets Portfolio Manager at the international business of Federated Hermes, prompts investors to take a longer-term view, where moderate growth in China could lead to a sustainable future.

If you were to ask investors what progress looks like in emerging market economies, the responses would be unanimous; corruption to come down, governance to improve, stronger and more stringent environmental standards, fewer monopolies, nurturing of innovation and an improved standard of living for everyone. China has progressed on all these aspects under the Xi Jinping administration.

Since 2012, Xi Jinping has driven an anticorruption crackdown targeting party, government, military and state-owned company officials suspected of corruption which has led to a number of investigations and prosecutions. This year, China’s State Administration for Market Regulation targeted tech companies with anti-monopoly rules. Whilst China is currently facing a difficult energy dilemma, we cannot deny the efforts made to target polluting industries and set ambitious goals to reach net zero as one of the world’s largest contributors to greenhouse gas emissions.

Two sides of every story

Stock markets may fear this rapid regulatory onslaught for a preference for short-term profits, but investors should hasten to take such a short-term view and instead see the long-term picture. Whilst China’s approach and the speed at which regulatory frameworks were implemented could have been more delicate, the steps taken under Xi Jinping are in the right direction to build long-term sustainable growth and meet goals of uplifting the standard of living for the masses.

Slower growth is inevitable but should not be feared. Moderate growth means lower leverage, filtering out collapses such as that of Evergrande, China’s second largest property developer currently facing bankruptcy and failing to pay its debt investors. From a global perspective, slower growth translates to consuming fewer resources which would otherwise be expensive and environmentally harmful, with every effort now being considered an urgent and crucial step towards net zero.

The actions taken by China will be also likely be mirrored by others; the US is currently looking at controlling and breaking up its tech monopolies and we have seen very elaborate data protections laws coming out of Europe. China has the liberty to take immediate and aggressive action over other democracies where elections present more hurdles to implementation. In short, yes there is volatility but further ahead, a sustainable future likely awaits.

Building blocks of the future

It is no secret that China has been cutting down on its excessive behaviours and it continues to taper leverage. The impact of China’s highly levered housing sector has been unnerving for investors with the fallout of Evergrande.

Another highly-levered sector in China was infrastructure. However, over the last few years, infrastructure projects such as high speed rail which could not be economically justified were cancelled. China is now reorientating it’s spend away from vanity projects to crucial ones such as the modernisation of the grid. We are yet to see a similar focus on modernisation of the grid elsewhere in the world. One of the most critical elements behind decarbonisation is electrification. If we are to move away from gasoline and coal, the grid needs to be strong and agile to accept renewable energy.  While the markets won’t favour moderating growth in infrastructure spend, but in our view, quality of the spend is better than quantity.

Within our portfolio, we have held Nari Technologies for over three years. Nari is a leading company in China which offers secondary equipment (software) to the grid. This is a high-quality company operating at the cutting edge of grid technology, enabling the agility needed for renewables. Prospects of the grid spending environment will be strong for years to come and this company is set to benefit.

Digitalisation and connectivity

China’s crackdown on tech may seem like a red flag to investors, especially with the latest antitrust fine of a $534 million to have recently been slapped on food delivery giant Meituan, following that of Alibaba in April. Yet despite regulatory pressure, opportunities still exist.

One thing is clear - the low hanging fruit of the sector have evaporated and companies have to truly innovate to survive and succeed. Whilst it may seem counter intuitive to look at this sector, growth potential has increased and valuations have come down. The sheer amount of work going into digitalisation and software is astounding, so we have increased exposure to China software companies and more widely across EMs.

However, the B2B space is where we see larger potential. Regulatory pressure is calmer and many companies are perfectly aligned with China’s policy goals for localisation and decoupling from US technology dependence. and Through EV battery technology, 5G and 6G patents, robotics, and rapidly growing biotech capabilities, Chinese companies will be leading the way in a future that is going to be more digital, electric, connected, and customised. China is a driving force providing the building blocks for this future.

Whilst risks do of course exist, volatility creates opportunities for stock pickers. Investors should take a patient approach and see the long-term potential in China’s future.

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