China’s techtonic shift
China’s technology sector is among the world’s worst performers since February. For example, at the time of writing, the CSI Overseas China Internet Index is down by more than 50% from its peak.
This has largely been the result of increasing regulatory intervention. It’s worth noting that this didn’t start this summer; it actually began back in November 2020 with the Ant Group’s IPO suspension. Since then, further waves of regulation have focused on DiDi* and the country’s education sector. These rulings have come from China’s Central Committee, so are unlikely to be reversed.
It took a while for investors and China’s own tech giants to realise they were witnessing a structural shift rather than a series of idiosyncratic events. That finally changed with the investigations into DiDi in early July; there’s since been a stream of announcements catching areas like gaming, education and food delivery.
We agree that the sector’s fundamentals have materially deteriorated through all this, with a lack of transparency and likely lower future earnings growth justifying lower valuations, but we don’t think it’s in China’s interests to destroy its tech champions.
Instead, we think the most likely scenario is that these moves are about ensuring firms are better aligned with the country’s social and political goals; these include promoting social welfare (e.g. education, gaming for minors), protecting sensitive data (from foreign ownership and overseas IPOs), reducing financial risks (by curtailing fin-tech), reining in financing (such as via listings abroad), and fostering hard tech innovation and self-reliance (including in semiconductors, AI, and advanced manufacturing, rather than more consumer-oriented firms).
Crackdown and back up?
So, at what point could these stocks become interesting to investors? Sentiment towards China’s tech sector seems rock bottom. One high-profile tech fund sold most of its holdings and there are signs that bad news now isn’t moving share prices much. Last week, for example, China issued a five-year blueprint for regulation of tech and other sectors and stock markets weren’t really affected. Similarly, Alibaba* was recently flat after a tax-rate increase led to a profit warning and news of an internal scandal broke.
We still favour some caution at this juncture, though. The lack of regulatory and political transparency creates a higher threshold for us to buy. It remains unclear both how long this regulatory drive will last and how severe it will be, so we have no visibility over the earnings impact for the next few years. Anything – from a temporary regulation blitz to send a strong message, to turning large parts of the private sector into state-owned enterprises – is possible.
We have therefore set out some signposts to monitor developments. The results of the DiDi investigation are expected in late August or early September; that outcome, which could range from a fine to de-listing in the US and asset sales to the government, will give an indication of the regulators’ intent.
We are also seeing some companies adjust their own behaviour to get ahead of the regulator. For example, Tencent* introduced new limits on children’s time on video games, hours after the state media described online games as ‘spiritual opium’. Weibo* also removed an online list ranking celebrities after state media were critical of celebrity culture. This self-correction is consistent with the Communist party’s encouragement of ‘self-criticism’.
Finally, the Politburo meeting on 30 July brought no new headlines on the topic. No news is good news here, as it suggests no further escalation.
Our approach, therefore, would be to lean against any overshoot to the downside and in that case look to increase Chinese tech exposure. To this end, some strategies have already sold puts on the Hang Seng China Enterprises Index, as the premium earned is particularly high given investors are already so negative.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.