Active Thinking

At GAM Investments’ latest Active Thinking Forum, three of our brightest investment minds discussed the drivers behind policy change in China, Japanese equities and political change in the country and why the recent correction in luxury equities may present a buying opportunity.

13 September 2021

Jian Shi Cortesi – China Equities

Following a significant summer correction in China equities, primarily due to regulatory change, it is important to look beyond the market moves and focus on the drivers behind policy and to consider what is likely to happen in the coming months. China is undergoing a paradigm shift in policy towards ‘common prosperity’. Previously authorities had been content with wealth creation. Currently the richest 1% own 30% of China’s wealth and the bottom half own less than 10%. A widening wealth gap is creating some social tensions. This is not dissimilar to other countries, and those countries have often seen frustration over the wealth gap channelled in the form of elections. In China, with a mission to ‘serve the people’, the government has outlined three wealth gaps to address – urban versus rural, rich versus poor and coastal regions versus inland areas with below average incomes. The ultimate goal is for a more harmonious society, reduced social tension and improved physical and mental wellbeing for citizens. It is not about equal wealth and income, but rather helping the poor prosper.

As we have seen, the regulatory change covers many areas, including the internet, housing and tutoring. Can Chinese companies continue to make a profit? We are confident many can adapt well. Ultimately, China is not against private firms as the sector is crucial to economic growth – private companies are responsible for the creation of 90% of new jobs. Going forward, China will continue to face the same policy dilemma – too much regulatory tightening in sectors may lead to panic, reduced investment and lower economic growth, whereas loose regulation causes disorder and heightens the possibility of fraud and low standards. We expect policy cycles to continue to drive China’s equity market. For now, policy uncertainty has driven down stock prices and is creating buying opportunities. Rising star companies may also benefit from a more level playing field in various sectors. In the consumer and technology spaces, valuations of some companies appear attractive following the correction and in the long term we continue to see opportunities in renewables, tech, semiconductors and high-end manufacturing.

Reiko Mito – Japan Equities

Japan has seen something of a short-term setback, which can be attributed to a number of factors. There have been concerns about delays to the Covid-19 vaccination programme and economic normalisation and there was a consensus view that the outperformance of Japanese equities had run its course in early 2021 when the recovery in China and the US proceeded faster than expected. Governance issues among famous Japanese brands such as Toshiba and Mitsubishi Electric have unsettled investors, but it should be noted these are company specific matters and overall governance is improving. An added concern is political uncertainty in the wake of Prime Minister Suga’s announcement that he will step down at the end of his term, amid mounting pressure after struggling to contain Covid-19 cases in the country.

We see a number of reasons to believe Japan will bounce back after lagging other global markets. June quarterly earnings were better than expected and solid fundamentals are likely to be reassessed. The vaccination programme has accelerated since late May and is catching up with those of major Western countries – the social pressure for people to get vaccinated remains high. The recovery of production based on domestic, not just external, demand has also begun. While any rapid rise of interest rates remains a risk, we view that as unlikely; it is worth remembering a gradual rise in interest rates is evidence of a sound economic recovery. We also continue to keep an eye on any potential resurgence of US-China friction.

We are already beginning to witness a recovery, with the manufacturing sector in particular driving the market. The ability to move production lines has been key; following Covid-19, structural change is underway to enable further production automation and an acceleration of investment in new technologies. Environmental, social and governance (ESG) factors are also increasingly gaining attention in terms of how companies manage suppliers, with supply chain upgrades including environmental performance and traceability anticipated. The recovery of consumption is likely to start in earnest in the fourth quarter of this year, as dining out and travelling, which account for a large part of household expenses, make a return from their reduced levels due to the pandemic.

There are a number of investment opportunities which appeal to us at present. We are seeing pent-up demand in the capital goods sector for production machinery that contributes to the environment, fuel efficiency and production yield. Digital transformation is also occurring, which should effectively enable companies to boost their top line without increasing fixed costs. Capital expenditure is solid, which suggests long-term growth.

Swetha Ramachandran – Luxury Equities

As luxury brands unveiled their Q2 2021 results over the summer, the robust operating performance of the sector soon became clear. On average, we have seen an acceleration in revenue growth on a two-year stack with solid trading in major geographies including China, the US and Europe. Meanwhile, margin expansion has been substantially better than expected and is likely to be retained by stronger players. Most European luxury stocks had in fact hit all-time highs by mid-August, until comments from China on ‘common prosperity’ led to a sharp selloff. Officials have pledged to expand the size of China’s middle-income group, grow the earnings for low-income groups and prohibit illicit income to promote social fairness and justice, and ‘reasonably adjust’ excessive incomes. Importantly, though, this is intended to create opportunities to recruit new consumers rather than target the super wealthy.

Ultimately, luxury demand, particularly in China, is correlated to the growth of the middle class, not the ultra wealthy. We therefore regard policies to ‘create opportunities for more people to become rich’ as a long-term positive for the luxury sector and see the risk of knee-jerk measures to restrict consumption as unlikely. We also believe the sector de-rating offers a compelling buying opportunity heading into the festive shopping season and beyond, with household savings rates still at record levels. The luxury sector tends to move past corrections quickly and rebound strongly – given healthy fundamentals, we expect this will be similar this time around. Longer term, the sector remains ideally placed to exploit emerging market growth at a developed market cost of capital. The gap between the winners and the losers is the widest it has ever been and we believe bottom-up stock selection and active management is key to exploiting the investment theme.