What is going on with Chinese equities?

In our view, periods of extreme market disparities often prove the most lucrative. Today, high levels of macro and political uncertainty — and the collective insecurity of investors — have inspired extreme disparities across equity markets. Asset prices are out of joint.

Questions about global growth (recession or soft landing?), inflation and rates (continued policy tightening* or a pause?), and geopolitics (US/China détente or increased hostility?) have unsettled investors. The collective emotional response has been to lurch into perceived areas of “certainty,” including artificial intelligence, India, and most recently emerging markets (EM) debt — and we believe there are clearly bubbles in pockets of these segments. Similarly, areas of uncertainty, particularly China, have been almost entirely shunned.

In our view, there are massive opportunities in China today. In this commentary, we discuss the drivers of recent underperformance and highlight areas where we believe the skeptics are focusing on the wrong issues.

Recent underperformance has been striking

Excluding China, returns across EM have been fantastic recently. For the 3-year period ending June 30, 2023, the Morgan Stanley Capital International Emerging Markets Index EM-ex China Index returned 32% in US dollar (USD) terms, approximating the bull market returns of the S&P 500 Index (44%)¹.

In the same period, Morgan Stanley Capital International Emerging Markets Index China lost 32%. Given China’s 30%² weight in the MSCI EM index, this has led to a material drag on overall EM equity returns.

So, what’s wrong with China?

Something is clearly afoot. China was widely expected to be one of the big global equity market stories in 2023 as the country suddenly abandoned three years of draconian pandemic restrictions. Investors bet heavily on the recovery, with the CSI-300 Index, a broad index of China’s largest domestic stocks, rallying 20% in USD terms from November 2022 to January 2023³.

However, investors bailed quickly as evidence of the recovery proved disappointing.

What’s really going on in China? In our view, China is going through an unusual existential shock in confidence. And absent more significant economic reform, we expect China is going to see lower nominal growth.

China is experiencing a crisis in confidence

China has historically been the standout among emerging markets. Its economy has expanded 12-fold from $1.5 trillion to $18 trillion over the past two decades⁴! This growth period has been underpinned by relentless optimism, a rarity across the developing world. Analogous perhaps only to the US, China has been characterized by an abiding faith in its future.

But today, we believe China is navigating through its first really significant crisis in confidence since the restructuring period of the 1990s. And absent any major economic reform, we expect China is going to see lower structural nominal gross domestic product (GDP) growth.

Anxieties have primarily manifested in a broad-based unwillingness to invest in long duration assets.

• Take the stock market: The CSI 300 Index is sitting below levels achieved in 2015 and below levels achieved at the peak of the stock market in 2008⁵!
• Or real estate: Housing sales have collapsed with no evidence of a material recovery forthcoming, despite record low mortgage rates.
• Or capital spending: Private sector investment remains largely on strike, with businesses focused on consolidating balance sheets and cutting costs.
• Perhaps most striking, there’s been a dramatic fall in family formations, both marriages and births, which is perhaps the longest duration investment for individuals.

Fears of a debt bubble or property bubble are misplaced

It’s unclear whether these anxieties are temporary or more existential. Nevertheless, we believe long-term skeptics on China are really focused on the wrong set of issues: debt and housing. Predictions of a “Minsky” moment**striking China is, in our view, entirely misplaced. China does not have a debt bubble that is going to take down the economy. And China does not have an outsized property bubble.

• The debt boom in China is long over. While China did grow domestic debt at an alarming rate 15 years ago as policymakers responded to the Great Financial Crisis in 2009, it has not grown aggregate debt for a very long period of time. In fact, broader debt levels have stabilized relative to nominal GDP for the past 7-8 years, with significant corporate deleveraging during this period as policymakers focused almost entirely on financial stability at the expense of growth.
• China’s boom in real estate peaked nearly a decade ago. Over the past 10 years, there has been no increase in housing sale volumes. And while long-term prices on a national basis have been breathtaking over the past 20 years — and have created a lot of wealth along the way — nationwide real estate price gains have been considerably lower than growth in nominal disposal incomes. So, China is unlikely to see a broad meltdown in the housing sector that ignites a “Minsky” crisis.

Structurally slower macro growth is almost inevitable

This is not to say, however, that the decline in housing sales volumes will not act as a structural drag on economic growth. That is, in fact, what we have seen for the past 5-10 years. As we have long argued, China’s real problem is the need to find a new growth model to compensate for the structural drags of peak exports and peak housing, which have been the two dominant economic growth drivers over the past quarter century. This is the real challenge for policymakers.

We see a few potential solutions, including redistribution (expansion of China’s thin social safety net) and development of China’s dormant capital markets. Both of these would dramatically increase consumption, investment, and productivity across the country. But neither of these seem, at present, to be top of mind for policymakers.

But we expect China’s growth to be higher in quality

Absent more thoughtful long-term economic reform, we are left with China growing more slowly — more in line with the rest of the world. What we expect to see in a slower growing China is more competitive discipline, improved capital allocation and growing consolidation. These are all conducive to improved returns on capital for industry leaders.

Moreover, we believe a slower growing China does not inhibit investment opportunity because, like the rest of the world, China has a number of structurally attractive companies that in our view exhibit characteristics of durable growth, sustainable competitive advantage, strong governance, and a host of real options embedded in their franchises.

Case study: H World and the Chinese hotel industry

Our team sees considerable opportunity within a narrow cluster of structurally attractive companies. Case in point, H World, the leading hotel operator of China⁶. China’s enormous hotel industry boasts 361,000 properties⁷ versus 56,000 in the US⁸. However, it is unusually fragmented, with branded chain hotels representing just 35% of the total hotel rooms⁹ versus 72% in the US and 41% of the global average¹⁰.

H World operates one of the largest hotel networks across China, with more than 8,500 hotels and a well-developed arsenal of 25 brands ranging from lower-cost to higher-end options.¹¹ Given the significant competitive advantage of its brands, we see considerable opportunity for H World to consolidate the market, particularly with a membership/loyalty program of 199 million members¹². We expect H World to grow its franchise hotel network at a double-digit compound rate for the next 10 years. This follows on a 45% increase in H World’s hotel room count over the past three years, reaching nearly 800,000 rooms at year-end 2022¹³. In contrast, we estimate that Chinese hotel industry total room count has fallen by more than 17% since 2019¹⁴.

The backbone of H World’s successful growth strategy is all about franchisee economics. The company offers significantly better returns to franchisees through its unparalleled distribution (lower marketing costs and higher occupancy rates), compelling brand portfolio (superior pricing), and superior operations/technology (lower operating costs). The economic damage of the pandemic period has amplified property owners’ need to convert to brand networks such as H World. Importantly, expansion plans further support a structural shift in H World’s portfolio mix towards mid/upscale segments, which could increasingly result in higher average tariffs (mid/upscale rooms have increased from 30% of total rooms in 2018 to 50%+ in 2022)¹⁵.

We expect that the combination of room growth, rising tariffs and a cyclical recovery in occupancy will result in strong revenue growth over the next five years. There is enormous operating leverage in H World’s business as almost all of its future network growth is expected to come via franchise room expansion. Hence, we expect a material upward expansion of operating and margins and free cash flow generation.

Conclusion

As experienced emerging market investors recognize, extreme periods may present opportunity for the patient. We see substantial polarization of markets today, with perceived macroeconomic “certainty” being priced exceptionally tightly and valuations looking exceptionally attractive in areas of uncertainty, most notably China. We believe, the broad-based pullback in Chinese equities over the past few years presents considerable opportunities to invest in structurally attractive companies with durable growth and sustainable advantage at unusually attractive valuations.