Over the past week, a lot of you have reached out with concerns about Evergrande and China’s growth:
Hi FH, if you don’t have exposure to China how best to build a portfolio in this set-up. Am getting excited to hear from you with the best sectors to buy in.
My gut feel is this round China’s slowdown is real & the property market might be tip of the iceberg. Great to have your thoughts.
Now a lot of the commentators out there are looking at this as a binary scenario.
Either we have Lehman, or we have a buy the dip moment.
The reality is far more nuanced, so I wanted to use this article to share latest views on China. I hope that it will help you in your decision making.
Updates on Evergrande (Week of 20 Sep 2021)
To round up what happened the past week:
Monday, 20 Sep: Evergrande missed payments to at least 2 China banks
Wednesday, 22 Sep: Evergrande said a Rmb232m ($35.9m) interest payment due on Thursday on an onshore bond had been “resolved through off-exchange negotiations”.
Thursday, 23 Sep: Evergrande HK shares jump 17% on news that the onshore bond payment was resolved.
Thursday morning, the People’s Bank of China injected a net Rmb110bn into China’s financial system, the biggest liquidity boost in eight months.
Evergrande, with $20bn outstanding in dollar-denominated debt, faces $83.5m in interest payments due on Thursday.
Friday, 24 Sep: As at midnight on Thursday, Evergrande has not made the interest payment under their dollar bonds. They have a 30 day grace period to make payment before it triggers an event of default.
Wall Street Journal reports that that local officials are told to prepare for a controlled demolition of Evergrande:
The officials characterized the actions being ordered as “getting ready for the possible storm,” saying that local-level government agencies and state-owned enterprises have been instructed to step in to handle the aftermath only at the last minute should Evergrande fail to manage its affairs in an orderly fashion.
For now at least, the base case scenario we discussed in last week’s article looks the most probable – controlled winding up of Evergrande.
Highly unlikely that CCP will allow house prices to drop – this will create Lehman / Japan v2
First things first – let’s discuss what will not happen.
What will not happen, is that real estate prices in China will not be allowed to collapse.
The reason why, is that 40% of Chinese household assets are in real estate.
Let’s just imagine you as a Singaporean go out there and you take up a $1.5 million loan to buy a $2 million property. And now the Singapore real estate market collapses, and your $2 million house is worth $1 million.
How upset would you be with the government for letting this happen? Would you cut your household spending?
Yeah – the Chinese are exactly the same, only their houses are even more expensive than us.
For political and economic reasons, this cannot be allowed to happen.
There are also systemic reasons here.
Most local provincial governments in China use future land sales as collateral to raise money via local government financing vehicle bonds (LGFV). This amounts for 30% of onshore bond debt. If land prices go down, their ability to finance goes down, and you have a financing problem.
And don’t forget that most companies in China are heavily invested in real estate investments and financing. Real estate related activities accounts for almost 30% of China’s GDP.
Long story short – if nominal real estate prices go down, China’s economy will go down. It will truly be a repeat of Lehman or Japan in the 1990s.
In any case, CCP is well aware of this.
The past week, Chinese cities have asked developers to “stop discount gimmicks as local governments seek to prevent a collapse in home prices”:
- Authorities in Zhuzhou chide developers and agents for offering homes that are priced ‘obviously lower than the market level’
- Huizhou warns that if some units are priced below the approved levels in the city, all homes in the project will have to sell at the same discounts
But, the deleveraging is key to future growth
A bit of background here.
Much of China’s growth the past 10 years was fuelled by leverage.
They borrowed a lot of money, built a lot of stuff, and had massive GDP growth.
The problem with leverage fuelled growth, is that it’s like a drug.
At first a small bit of leverage does wonders. But over time, the system develops an “immunity”, and inefficiencies build up.
You need more and more leverage to achieve the same results.
Just like with drug addicts – at some point the amount of leverage you need to get the same “hit” becomes unsustainable, and the whole system comes crumbling down. We saw this in Lehman, we saw this in Japan. Almost all real estate driven booms end the same way.
China knows this too. Even in 2018 they were actively trying to bring down real estate leverage, which was what kickstarted the Evergrande and China Fortune Land problems.
Then COVID struck in 2020, and they had to put a pause on the deleveraging to return the economy to growth.
But this time around, they look serious about deleveraging.
The choice is simple really. Either you deleverage now and position for future growth. Or continue with leverage and inefficiencies, which only makes the eventual deleveraging even worse.
Given the 20th Party Congress late next year, and the ongoing tech crackdown, the former makes a lot of sense from a timing perspective.
You can look at the chart below – real estate investment as a % of GDP is too high for China. A lot of that money needs to reposition towards more productive parts of the economy like tech and manufacturing, if China wants sustainable growth.
Best outcome is a China real estate / construction slowdown?
So FH, are you saying the best outcome here is that we avoid contagion, but we have a China real estate slowdown?
Unfortunately, yes.
The best case is that China bails everything out and party goes on.
But c’mon – let’s be realistic. That’s what the China Tech investors were hoping for since Dec 2020, and look how that played out.
Whether rightly or wrongly, I think China is serious about the deleveraging this time around. Evergrande is going to default.
The worst case is Lehman.
An uncontrolled insolvency of Evergrande that spreads quickly to the rest of the real estate sector, and eventually the financial sector in a repeat of Lehman.
Again, not likely because CCP will try to stop the second and third order effects. You can see instructions already being given to government officials and SOEs to avoid this.
So if you can’t have a quick default, but you still need to deleverage, then you need to accept slowing growth.
Goldman has modelled the impact of a property sector slowdown on China’s GDP, and even the most optimistic scenario models a -1.5% impact to GDP growth.
BUT – CCP is human after all
But, and that’s where I think the nuance comes in.
Everything will rest on the execution.
Everybody assumes that Xi has this magical phone – that he just has to make 1 call and the problem goes away.
In reality, China is a sprawling country with many levels of bureaucracy.
To put things in perspective – there are 10 million civil servants in China. That’s basically everyone in Singapore, men women and children, times 2, working for the government in China.
It’s incredibly hard to manage and run a system that massive. Just getting everyone to pull in the same direction is already a feat in itself.
The fact that CCP has done so to date is testament to how good they are.
So… will CCP manage to control the second and third order effects of a Evergrande winding up?
Base case – yes, most likely.
Am I willing to bet my life on it? Hell no.
There is a chance that things could go wrong here. As investors – it’s important to be alive to this possibility.
Real estate is 42% of the Asian high yield bond market, which most of it coming from China. If things blow up, they can get ugly real fast.
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China’s Growth will shift
As the crackdowns play out, we’re starting to see Xi’s vision for the new China.
Namely – more regulation, clamping down on software tech, redistribution of wealth, capital reallocation (“common prosperity”), deleveraging, getting rid of bad behaviour etc.
Pivoting the economy away from real estate and non-strategic software tech.
Into things like hi-tech manufacturing, robotics, electric vehicles, semiconductors.
Officials keep talking about moving away from the US model of financialization, and into the German model of manufacturing driven economy.
This is starting to make more sense by the day.
How best to invest in China for investors with no exposure?
Back to the reader’s question – how best to invest in China if you have no exposure right now?
It really depends on your risk appetite.
If you want something that is immune to the crackdown, then you’ll want to go for the sectors that are untouched:
- Manufacturing
- Semiconductors
- Consumer Goods
- Electric Vehicles
And so on. Full list of individual stock analysis can be found on my China stock watch on Patreon.
If you have a higher risk appetite, and you don’t mind going into areas that are actively being cracked down on and try to bottom fish, then you can look at:
- Consumer internet
- Real Estate
- Financial Institutions
This is the high risk high reward play, with the potential to blow up. Think names like Ping An, ICBC, Alibaba, Tencent etc. Again, for the full list check out the China stock watch.
Is Xi the next Stalin?
I was reading an intriguing report the past week that drew parallels between Xi and a notorious dictator – Stalin.
Both understand the power of narrative, the criticality of maintaining control, and the power of the media. And both were ruthless when it come to getting rid of opponents.
Now whether Xi turns out to be the next Stalin I don’t know.
Only Xi himself knows what he is thinking.
But it’s definitely a possibility, and one we as investors need to be alive to.
Will I sell my China stocks?
For me personally, my exposure to China today is mainly consumer tech, real estate via Singapore listed REITs/Developers, and a small position in China FIs.
On a portfolio basis, I am still underallocated to China as compared to Singapore and the US (Full portfolio breakdown available on Patreon).
If my entire China position goes to zero, sure it’s going to hurt, but it’s not the end of my investing career.
I still remain bullish on China longer term. Call me an optimist, but I believe in the power of the Chinese people. It’s 1.4 billion people struggling for a better life.
As long as the CCP creates a stable political platform, China’s economy will boom.
So I actually plan to increase my allocation to China going forward.
I have a healthy risk appetite, so sectors I like are:
- Consumer tech – but the key is to avoid those that are non-strategic that will not survive the crackdown
- Real Estate / FIs – but Evergrande will take some time to pay out, so I will need to be patient on this front
- Hard Manufacturing / Consumer Goods – Not touched by crackdown
If you’re keen, do follow me on Patreon where I share my portfolio moves on a weekly basis, and in depth analysis on the China names.
Closing Thoughts: Timing and execution will be key
What is clear though, is that significant uncertainty for China lies ahead.
The 20th Party Congress (where Xi needs to be “re-elected” for a third term) only takes place in second half of 2022.
That’s another 9 – 12 months or so from today, which leaves significant uncertainty on the crackdown that lies ahead.
This being a man made move, it’s hard to predict exactly how it plays out. We just don’t know what we don’t know.
So some caution is warranted. Be flexible, and keep an open mind.
Things move very fast in markets these days, both on the upside and downside.
As always – love to hear your thoughts! Are you still bullish on China after this?
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As always, this article is written on 18 Sep 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patreon.
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Hi FH,
Interesting and insightful as usual. Valuations of both Tech and Financial institutions are very attractive vs recent historical norms now, a function of the uncertainty and volatility we are seeing.
Ultimately, there is only one real question that matters – will the US succeed in suppressing China and its continued development or not? Many assume that the US will not be able to do this but I think the answer is not so clear cut. One only needs to look at Huawei – from being #1 in 5G and almost #1 in mobile phones to being an also ran in just a couple of years. The US has multiple wide and deep alliances while China has almost none that matter. It controls the global financial system and many tech levers. Japan was effectively suppressed by the US through the 1985 Plaza Accord and has never recovered from it.
So if the US is successful, all bets are off. If not, China will continue to grow and things will recover.
Given the uncertainty around specific events e.g. regulation of yet another sector, bank exposure to Evergrande or the next Evergrande (it will not be the only one), then betting on individual counters is particularly risky. But valuations are the most attractive in years.
So in this environment of attractive valuations but clear but unpredictable risks, I would rather go with an index fund approach and just dollar cost average in every month over the next year or two if one believes that China will find a way to survive.
Hi Chan Mali Chan,
Very interesting perspective. Which ETFs are you going for – MSCI China?
China has been a very polarising topic of late, this is apparent even from the comments section for this article.
Some are sanguine, some think China is uninvestible, while some remain bullish. Just a couple months ago sentiment was still very bullish, so this is an interesting development!
I am looking both a broad Hang Seng Core Index as well as a Hang Seng Tech index.
If China is suppressed, it will be a net negative for the world as it has been a key driver for global growth in the last decade. Global inflation will also inevitably rise and the quality of life of people everywhere, including in the West, will decline.
The negative impact on Asia would be even greater and Australia will certainly start having more frequent recessions.
So I am hopeful that people will be sensible and find a balance to accommodate the increasing weight of China.
I think your worries are overdue, you are talking about a civilization of 1.4 bn that overcame all odds. It has survived many kinds of wars, disasters and calamities including great famines and the commie revolutions. The spirit of such a country is ‘never say die’. Where else can you find such a country? Supression can only work for so long. Eventually will be overcome as well. As a sgrean, I am more bullish on china than US as the latter only knows how to print $ and hit the debt ceiling. Even a lot of the high tech in US are created or founded by Chinese. Look at nvidia, amd, So many chinese work in SV , faang, etc. also I dont think Us can solve its serious domestic problems. No empire last forever, even without china , Us will probably decline by itself.
Yeah I agree that China will emerge on the other side. I don’t see how the US can supress China long term, this is a multi-decade long move. It will not succeed any more than the UK can suppress the US 100 years ago.
I suppose the key question is what is the best way to play it as investors.
Even if we have a view that China will eventually grow to rival the US – expressing that into a tradeable idea is the tricky part! And I think for that we may need to let it play out slightly more, we may still be in the early to mid stages of this structural transition.
I bought GlobalX China Semicon ETF amongst many other stocks. The top holdings are all semi-related companies that are growing rapidly.
This will be a long-term play though.
Short-term I will buy undervalued stocks like Ping An, Baba, Tencent, Sunny, Xinyi Glass. There are quite a number of classic fairly-valued high-growth companies that I don’t have time to research
Huawei’s phone sales went to xiaomi and other Chinese phone makers. Still china benefiting. And they are leading 6g at the moment. US doesnt have true 5g mass infra at the moment. I belive within 10 years china will be more self-sufficient and decoupled from US tech. World will probably be “split” into 2 blocs. Not to forget The population size of china is more than US + Japan + EU combined. So you are overestimating the strength of US+allies. Small countries like Australia , canada and Japan make a lot of noise but their own economies are quite dependent on china , and Japan and US are suffering from high debt levels and low GDP growth/stagflation. US has so many domestic problems that are very difficult to resolve and their weak governance make it all the more difficult. China has no formal ally but it has friends as part of BRI that will help to boost china growth. US allies are mainly lapdogs or vassal states . Even EU is now considering pursuing its own defense and strategic policies following from the fall out of Afgh and nuclear submarine deal. It remains to be seen who will outlast who.
https://www.cfr.org/blog/china-huawei-5g
“US allies are mainly lapdogs or vassal states.”
This comment.. I fully agree. And the vassal states seem to have no qualms on expressing this openly. Australia is a Mining + Housing economy that is so dependent on China.. but seeks to make an enemy out of China, primarily because it is just a vassal state.. While we wouldn’t know yet who will outlast who.. I am confident the Aussies likely dug their own graves.
Read this article: https://www.scmp.com/week-asia/economics/article/3151634/evergrande-sinic-fantasia-tidal-wave-chinese-debt-about-sink
Will it spell doom for Australia? As investors we all know that commodities biz have no moat… China is making friends with resource-rich Africa, Middle East, etc. Once China is able to pivot away from Australia…. what will happen? Will India be able to absorb the damage? India itself has lots of domestic problems to deal with…
Hi FH. I took a bite at Lion Global HS Tech ETF recently. Too lazy to pick stocks. Also vested in CLCT, Capitaland and MNACT to collect dividend, quite big positions. Hope they don’t sink. Lol. Can’t ignore the 1.4 billion people yea.
Haha looks like a lot of people are going with the ETF route recently for China.
My main concern with China is that this slowdown is going to take time to play out. And if China slows down, it’s unlikely to be contained to China given how big the China economy is. Throw in tightening monetary policy globally, supply shocks, slowing post-COVID growth, the next 3 – 6 months are tricky for global macro.
I think you should pause for a while writting about chinese tech articles. Its clearly a NO NO for quite awhile already. Been crashing so hard lately. If u have been buying last year or earlier this year, its been dipping so hard, its confirm your at a big loss now. The thing is its with the Chinese govt. Nobody knows what they are thinking about. You can be the best company in China with the most valuable tech ( Think alibaba and DIDI ) , but if the govt dont like you, means they don’t like you. they go all out to disrupt you. Its almost uninvestitable. Its weird why someone would try to glorify them now ? Don’t get me wrong, I agree they have a big economy, but its the government there that is hard to discern. You can have the biggest and most potential economy but if the govt regulations there is anti capitalist, then its hard. I think the logical stance now, should be to sit at the sidelines to observe first.
Don’t disagree with this.
I guess the question then – let’s say things play out like you say. Let’s say there’s blood in the streets, and all the institutional investors have fled.
What kind of valuations / conditions do you need to see before you go back into China again? Or is China a market that you would never invest in because of political risk?
In what way are the moves anti-capitalist? Except for that non-profit of core subject tutoring? If the goal of these so-called ‘crackdown’ is to create a more sustainable longterm development then we as investors should welcome it, although there is shortterm pain now. People really spout all sorts of nonsense when they are overwhelmed with FUD
Thanks FH for another insightful analysis!
I’ll add that Ray Dalio’s framework of a “beautiful deleveraging” may serve as a useful guide here: “A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.”
1) Austerity: Probably seen in relative terms with respect to other economies – China has not spent as much as Western governments and does not seem willing to do so.
2) Debt restructuring – Per your base case, China government seems likely to let Evergrande default (which will also set a strong precedent for other over-leveraged firms to clean up their balance sheets or else…), but in an orderly manner with few 2nd / 3rd-order effects. Certainly helps to clean out some financial stability risks and also makes future debt growth more sustainable.
3) Money printing: Pumping liquidity into the financial system in light amounts (e.g. recent RRR cuts) to counteract the drop in growth.
Outcome is slower but more sustainable growth (which really makes sense in light of a GDP growth target being absent from China’s 14th 5 year plan, alongside all the other policy objectives you mentioned).
In such a scenario, I’d nibble at some of the big FIs (to lock in very juicy 7-8% dividend yields), with the assumption that the contagion will most likely be contained.
Very interesting POV!
If things play out this way, it’s true that the big FIs could be a great way to play it. Already 6 to 7% yields now, if they tumble a bit from here that could be some very interesting dividend plays as long as the CCP holds it all together.