“Heightened Regulatory Scrutiny in China: What Investors Need to Know”

Market Overview:

“China has announced recent regulatory changes targeting specific industries, which has led to some heighted market volatility. This drip feed of ‘potential’ regulations constitutes a tsunami of uncertainties.”

China is in the midst of a tightening regulatory cycle, implementing anti-monopoly, data security and industry-specific regulations. Increased regulatory scrutiny, especially after the state media released a story on the addictive nature of online gaming and its potential adverse effects on China’s youth, has elevated market volatility and investor fears of further policy risks in China. There has been no shortage of regulatory developments, since the clampdown started amongst the Big-Tech early this year.

Figure 1: Hang Seng Index 1-year chart (Source: Bloomberg)

The underlying thread that ties the intense regulatory activities across many industries lies in Beijing’s determination to develop China into a “modernized socialist economy,” including objectives of common prosperity, green development and independence in key technologies/industries. Its purpose is no doubt to align these companies with China’s long-term strategic goals.

Given the role that innovation/technology has played in the productivity and gross domestic product (GDP) growth in China, we do not believe the government’s regulatory efforts are aimed at curtailing the digital sector’s growth as a whole. Rather, similar to many regulators globally, key objectives include removing monopolistic behavior, enhancing data privacy/security and improved outcomes for a broader range of stakeholders.

Regulatory cycles are not uncommon in China—policy and regulatory scrutiny should be seen as ongoing risks when it comes to investing in China, to be carefully monitored and integrated in company research and portfolio management.

In spite of this, the situation remains very dynamic and fluid, investors should remain cautious and expect volatility to be here to stay. Investors should shift their geographical exposure towards the US given the increased uncertainty in the regulatory environment in China/HK. It is also important to adopt a balanced and diversified portfolio.

Fixed Income Overview:

Investors seem to be turning their attention to Treasury yields as a form of precaution. We anticipate FED Funds rate to be kept 0% – 0.25%, with two rate hikes by the end of 2023. The 10-yr US Treasury dropped to 1.18% as of3rdAugust 2021 from 1.21% as of21 July 2021 and is expected to be around 1.0% to 2.0% for the year of 2021. The 10-yr Treasury yield has been at a low level for the past one to two months and there seems to be a steady inflow from other assets into Treasury.

The credit default swap (CDS)index for Asia ex-Japan Investment Grade entities rebounded slightly to 93 as of 3rd August 2021 from 87 as of21 July 2021. Asia IG credit spread increased to 139as of 3rdAugust 2021 from 133 as of 21 July 2021. Credit spreads are expected to be to widen slightly in the coming quarter. However, Asia HY credit spread continued to increase from 690 as of21 July 2021 to 887 as of 3rd August 2021. Sentiment continues to remain weak as adverse news continue to flow out of the Chinese Bond market.

Figure 2: CDS Asia ex-Japan Index 1-year Chart (Source: Bloomberg)

Highly leveraged HY bonds (B rated) may face refinancing risks, several onshore/offshore bonds have defaulted recently including bonds issued by Yongcheng Coal, Huachen Automotive Group, Tsinghua Unigroup, China Fortune Land Development and Tus-Holdings Co. Ltd. As the government support weaken, four Chinese AMCs (Huarong, Cinda, Orient &Great Wall) may be downgraded and their credit spreads may widen. We caution investors holding marginal investment graded bonds (BBB-, Baa3) to be wary of downgrades.For investors with an investment grade bond portfolio mandate, we recommend bonds with BBB+ ratings or higher, and portfolio duration of 3.5 – 4 years.

We again recommend investors to stick to short dated high quality (BB Rated) High Yield bonds excluding bonds issued by Chinese issuers with a duration of less than 3 years which would offer the best value. Investors should be prepared to hold these bonds to maturity. Geographically, we are overweight Emerging Markets’ bonds (Investment Grade and High Yield with BB ratings excluding China) and neutral on Developed Markets’ and Chinese bonds.

Further, we recommend investors to match their exposure of high-beta bonds such as: CoCo Bonds, Perpetuals, and high yield bonds to their respective risk appetites. It is also recommended for investors to hold a more diversified fixed income portfolio or to reduce leverage of portfolios due to various uncertainties across sectors and particularly to reduce/control portfolio exposure in high leverage BB-rating (e.g. Greenland, RiseSun) & all B-rating Chinese real estate bonds. We advise investors to dive deeper into the issuer’s stand-alone fundamentals to ensure the strength of the company.

We recommend investors to continue to monitor low beta bonds. For reference, the purchase yields for 3–5-year low beta IG bonds are at 1-2%, and 3-5-year low beta HY bonds are at 3-5%. Overall, we recommend a balanced and more diversified portfolio of high quality (BB rated) high yield bonds and short duration IG Bonds.
Although the absolute returns in the fixed income market may be low, it is still advised to maintain a portion of the portfolio in fixed income given the heightened volatility of the markets.

Equities Overview:

Equities in the US continue to retest previous highs as investors shrug off the resurfacing Covid-19 fears and its more potent variants. The markets have rebounded strongly, given its most recent pullback in July and has continued to show signs of further recovery especially after the FED continued with its accommodative outlook. Vaccinations have continued to be pushed out across the globe and economies now seem better equipped to deal with the coronavirus outbreak. Across the pacific however, continued regulatory headwinds continue to batter the markets as yet another industry was hit, this time the mobile gaming industry. Tencent (0700.HK), the social-media-to-gaming behemoth, fell 6% and NetEase (9999.HK) fell nearly 8% on Tuesday. This capped off a week-long selloff in Chinese stocks, resulting in its worst month in nearly 3 years.

Figure 3: 1-year chart comparing S&P500, Dow Jones Index and Hang Seng Index (Source: Bloomberg)

In the US, the July PMI (Purchase Managers Index) data came in below expectations and showed signs of cooling off, potentially signaling a slowdown in the economic recovery in the US. That being said, a marked slowdown in the economic recovery could give the US government and the FED more reason to continue its fiscal and monetary stimulus to support the economy.

Fiscal and monetary policies look set to remain accommodative in the short-term as central banks continue to adopt a more passive approach. We remain cautiously bullish for Equities towards the end of the year. We urge investors to stay constructive and selective in terms of stock selection and weigh their risk-and-reward. Volatility will persist, investors should take major pullbacks as a buying opportunity to increase their exposure in select sectors.

Our investment strategy stays largely intact. We are overweight both Cyclicals and Tech, with more skew towards Cyclicals which will be closely tied to the economic reopening. We prefer US Mega-Capitalized Companies which are constituents of the Dow Jones Index as they are less volatile and still provide decent upside potential. For Cyclicals, we continue to prefer subsectors such as Basic materials, commodities and Chinese Auto Manufacturers/Distributors. We are also wary of the regulatory housekeeping being done by the Chinese Government, therefore preferring geographic exposure in the US market.

It is important that investors adopt a well-diversified and balanced portfolio, with a skew towards cyclicals while maintaining a core thematic position in technology. In short, investors should employ a more back-to-basics stock selection approach and continue to adhere to company fundamentals and strict risk management principles (stop-loss mechanisms and/or appropriate portfolio hedging) to mitigate risks from market swings and uncertainties.