Understanding regulatory cycle is key to investing in China

Investors looking to gain exposure to the Chinese economy are all-too aware of the threat of regulatory actions after a number of government-initiated crackdowns took the market by surprise and led to share price crashed.

But the country is investible if the cycle of regulation is understood, Iain Cunningham told FTAdviser, as it works in tandem with the credit cycle.

“[The Chinese authorities] do not do interest rate policy like we do in the US or UK…they just tell the banks to lend more or less money, where to lend it and where to not lend it, and so China’s economy tends to get driven by a credit cycle.”

Typically, the regulatory cycle comes on top of that, he said.

“Whenever the economy looks pretty good, as it did heading into 2021, [the authorities] tend to enact policies to address longer-term structural issues that they perceived to be in place.

Through the back end of last year we were accumulating positions in that part of the worldIain Cunningham

“The regulatory cycle tends to get very quiet when the economy is weakened,” Cunningham said, as the Chinese government wants to improve confidence.

“Actually, you have seen them walking back on the macro prudential measure they put on the housing market and property developers.

"The language associated with internet platforms in the private sector has become far more supportive relative to where it was 18 months ago.”

The flip side of this is that when the economy improves, there will then be a high probability of new regulatory crackdowns.

For Cunningham, who invests counter-cyclically, this means buying assets with longer-term tailwinds that are attractively valued and have cyclical and policy support behind them.  

“Through the back end of last year we were accumulating positions in that part of the world because valuations were attractive and policymakers were indicating that the regulatory cycle was peaking.

“We believe there will be a period of time for say, one to two years where it is attracting to own and run those assets, and then should we get to a point when [assets are] more expensive, the economy has recovered, and policymakers indicate the are going to tighten again, we [will] significantly reduce our exposure.”

Future proofing

Cunningham outlined the key forces that he thinks will shape the next financial cycle.

“Some of those big forces [include] China's rise…we are seeing increasing pushback on that globally, which is causing elements of de-globalisation, particularly for national security reasons.”

This means countries will no longer be taking advantage of lower-cost labour, and will require capital expenditure and resource intensity to rework supply chains within nations and between “friendly” countries, he added.

All of this will add inflationary pressures to the economy.

As a result of the rising geopolitical risks, including the war in Ukraine and uncertainty over the shape of future relations with China, defence spending will also rise.

“Then, in addition to that, we have got climate change [and] a transition towards net zero,” Cunningham said.

We think this next cycle could have quite a lot of capital and resource intensityIain Cunningham, Ninety One

In tandem with this will be efforts to reduce reliance on certain countries for energy.

“To transition towards net zero, there needs to be a significant build out infrastructure, across all things, from expansions of electrical grids, to storage facilities, to wind turbines, solar farms, all these different sorts of things. 

“Again, we think that is…more capital intensive, it is more resource intensive.”

Another potential impact will come from the under-investment in resource extraction over the past eight years in particular.

“When you have a lot of demand for resources, and limited supply, we know what that can do to prices,” he said.

Finally, Cunningham said, he thinks US household deleveraging is broadly complete. 

During these periods, you [also] tend to get multiple compression in equity marketsIain Cunningham, Ninety One

“US household balance sheets look pretty healthy, and you've got the big millennial cohort now in the US moving through.”

This generation is in what Cunningham calls the “household formation” stage, buying houses and cars and raising families.

This is the part of life at which most families take on the highest amount of debt.

All of these forces contribute to an “inflationary impulse”, he said, in contrast to the previous cycle which had very little capital intensity, which is why it benefitted asset-like businesses, large-cap tech companies, pushing up equity markets and forcing down bond yields.

“We think this next cycle could have quite a lot of capital and resource intensity,” Cunningham said.

If inflation is higher and more volatile, central bank rates will also be more unpredictable and fast-moving, which has historically led to a higher correlation between equities and bonds.

This could prove problematic for the 60/40 portfolio which has been seen as a “safe” investment strategy, but is underpinned by equities and bonds moving in opposite directions.

“During these periods, you [also] tend to get multiple compression in equity markets, so you get a headwind to returns in general.”

When it comes to the companies that are likely to lead the next cycle, Cunningham points to companies that are involved in “building things” and contributing to the expansion of infrastructure and capacity as the beneficiaries. 

sally.hickey@ft.com