CHINA: RED MOON RISING - Franklin Templeton
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Perspective from
Franklin Templeton
Investment Solutions
CHINA: RED MOON RISING
August 2021 KEY POINTS
• China’s “firsts” drove early equity outperformance in 2020, but has given way to marked
underperformance in 2021, trailing global peers by 26% year to date (YTD).1
• Regulatory recapture and macro headwinds dominate the landscape in China—a renewed
regulatory push toward common prosperity, the re-emergence of COVID and limited
monetary and fiscal policy support—and are not expected to subside anytime soon.
• COVID’s comeback can’t be ignored as China begins to implement many heavy-handed
policies again to control the spread.
• Portfolio positioning will likely remain unchanged in terms of our less-favorable view on
Chinese equities this year. However, our view has slightly improved given the recent
sell-off and marked deterioration in sentiment.
THE TORTOISE VS. THE HARE IN THE YEAR OF THE OX
The classic tale of speed vs. perseverance has played out before us in global equity markets
since 2020. Early in the pandemic, China emerged as the hare, swiftly outperforming other
global equity markets through 2020 due to strong control over the COVID-19 outbreak,
quick monetary and fiscal policy accommodation, and resilient export growth. China initially
seemed destined to be this cycle’s “winner”—but not so fast.
While other global equities were initially paced as the tortoise, their slow and steady
approach has been paying off since the March 2020 low, with only two drawdowns of ~7%
since then.2 Now in 2021, global equities continued to rise, gaining 14% YTD,3 while the
Chinese equity markets have run out of steam and experienced a drawdown of more than
30% since February 2021, and are currently underperforming global equities by 26% YTD.4
CHINESE EQUITIES: Index rebased to 100 on January 2020
FROM LEADER TO LAGGARD 160
January 1, 2020–
150
August 17, 2021
140
130
120
110
100
90
80
70
60
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
2020 2021
MSCI USA Net Total MSCI China Net Total MSCI World ex USA Net MSCI Emerging Markets ex China
Return USD Index Return USD Index Total Return USD Index Net Return USD Index
For illustrative purposes only and not reflective of the performance or portfolio composition of any Franklin Templeton fund.
Sources: Bloomberg, Macrobond. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses
or sales charges. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms
available at: www.franklintempletondatasources.com.
CHINA’S “FIRSTS”
China’s early pandemic outperformance was based on the ability to execute effectively on
many global “Firsts”:
• China was the first nation to endure the COVID-19 crisis, with the initial outbreak
emanating in Wuhan before spreading throughout the world.
• China was one of the first nations to execute (and then emerge from) the COVID-19
lockdowns, perform contact tracing, and require public adherence to mask-wearing.
• China was a premier beneficiary from rising global goods demand, where its export
industry surged in response to higher demand for supplies including medical equipment
and housing- related goods.
China’s transition from leader to laggard was also due to another “first,” as China was the
first major nation to incrementally tighten its monetary policy stance following the
COVID-19 crisis. For instance, China’s credit growth had begun to decline as early as
January 2021.
A newfound sense of economic stability would eventually allow policymakers to resume the
battle on economic leverage, an issue that had eluded policymakers over the past
decade. For perspective, China’s nonfinancial private sector credit had more than doubled
from the great financial crisis in 2008, rising from 112% of global domestic product
(GDP) to 222%.5 During this same period, the debt levels of most advanced economies
merely trended sideways. Overnight lending rates climbed to their highest rate in six years
in January 2021.6
2 China: Red moon rising
CHINA’S CREDIT BOOM Nonfinancial credit (% of gross domestic product)
January 1, 2002– 230%
October 1, 2020 220
210
200
190
180
170
160
150
140
130
120
110
Jan-02 Feb-04 Mar-06 Apr-08 May-10 Jun-12 Jul-14 Aug-16 Sep-18 Oct-20
China Advanced economies
Sources: BIS, Macrobond.
CHINA’S REGULATORY RECAPTURE
Tightening monetary policy was the first shoe to drop in 2021, but not the last. As the year
progressed, a barrage of regulatory surprises stifled markets as Chinese policymakers
turned their attention toward their goal of “common prosperity for all.” Regulators started
zeroing in on giant technology platform companies, and most recently have turned to
China’s tech giants:
the private education sector as the cost of private tuition has become a burden for most of
Quick facts7
• Alibaba hosts twice as the parents.
much e-commerce activity
as Amazon Many of these regulatory initiatives are unlikely to end soon since they fulfill a part of
• Tencent has 1.2 billion China’s Communist Party (CCP) long-term strategic vision. The CCP has been putting
users and is the world’s together five-year socioeconomic plans since 1953 and are now on its 14th five-year plan
most popular app targeting years 2021–2025. The most recent 50 regulatory actions range from antitrust to
• China has 160 Unicorns data violations and green development—analogous to environmental, social and governance
(half are in fields such
(ESG) efforts in Western economies.
as artificial intelligence,
big data, robotics)
We do not think China will significantly curtail efforts to increase productivity, especially as
• Didi, which provides
transports, has more users
demographic headwinds are likely to pick-up in the upcoming decade. However, China is
than the United States outcome-oriented and is prioritizing “common prosperity for all”; regulatory intervention will
has people likely remain a key tool to achieve this outcome, and even increased market volatility is
unlikely to change this approach.
CHINA’S ROADMAP TO
A “COMMON PROSPERITY”
Environmental goals Social goals Governance goals
Decarbonization Rebalance economy toward labor Reduce data security risks
Peak emissions by 2030, carbon neutrality Lower costs of housing, health care and Enhance cybersecurity capabilities
by 2060 education
Enhance economic self-sufficiency
Provide retirement vehicles similar to
social security
3 China: Red moon risingCOVID’S COMEBACK
On top of a new regulatory reset, China is now dealing with a COVID-19 resurgence as the
Delta variant has permeated through the country. After the initial outbreak, China’s
defense against COVID-19 was laudable, as strict lockdowns and contact tracing initiatives
allowed the country to quell the number of cases and ultimately emerge as the first
nation to begin normalizing its economy.
Unfortunately, the Delta variant is estimated to be more than twice as contagious as
previous strains,8 making it much more difficult to prevent the transmission using lock-
downs. Full vaccination is viewed as the best protection against Delta, and here, China is on
par with developed market peers—China’s vaccination rate is estimated to be ~55%
of their population, according to China’s National Health Commission.9 This compares to
~50% and ~60% (fully vaccinated) for the United States and eurozone, respectively.10
China’s remaining challenge lies not only in vaccinating the remainder of their population,
around 630 million people, but also in coordinating this effort given the massive
geographic reach of its territory. Moreover, the efficacy of their two most common vaccines,
Sinovac and Sinopharm, has come under question as some studies have suggested
that they are less protective than Western vaccine rivals, such as Pfizer and Moderna.11
China has already begun to undertake draconian measures in response to the Delta
outbreak, enacting lockdowns in over 30 cities where clusters had emerged.12 This policy
response contrasts with many other nations that are refraining from lockdowns and is
likely to have a substantial effect on economic growth if sustained for any period of time.
MULTI-ASSET PERSPECTIVE
The macro environment in China presents several headwinds, which have clearly buffeted
Chinese equities this year. The question we ask ourselves: is the bad news already
priced in? Clearly, some of the news has been priced in as Chinese equities have de-rated,
both in absolute terms and relative to their global peers. Of interest to us at FTIS is
that some sentiment indicators appear to be near all-time pessimistic levels. This usually
serves as a good contrarian indicator. As Sir John Templeton used to say, “Bull markets
are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
CHINESE MARKETS HAVE Price-to-book ratio (log scale)
DE-RATED 4
June 1, 2012–July 1, 2021
2
1
Jan-12 Aug-13 Mar-15 Oct-16 May-18 Dec-19 Jul-21
China, Equity indices, MSCI, IMI (Large, mid & small cap), Index, price/book value
AC World, Equity indices, MSCI, IMI (Large, mid & small cap), Index, price/book value
Price-to-book ratio measures the current price of an index relative to the book value of the same index. It is a measure of valuation, where a
higher price-to-book ratio signifies a higher valuation.
Sources: FactSet, MSCI, Macrobond. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenes or
sales charges. Past performance is not an indicator or a guarantee of future results.
4 China: Red moon risingAs we weigh these considerations, the macro headwinds keep us cautious in regard to
Chinese equities, although we think it is reasonable to rethink our views given the recent
pullback in Chinese equities and sentiment. We are monitoring fiscal policymakers
for additional easing measures that could lead us to evolve our positioning and outlook.
CONTRIBUTORS
Gene Podkaminer, CFA Miles Sampson, CFA Michael Kerwin, CFA
Head of Research Senior Research Analyst Senior Research Analyst
Wylie Tollette, CFA Nick Hooten, CFA Subash Pillai
Head of Client Investment Regional Head of Client Regional Head of Client
Solutions Investment Solutions—Americas Investment Solutions—APAC
Peter Vincent Kent Shepherd Josh Greco
Regional Head of Client Senior Institutional Portfolio Head of Institutional Portfolio
Investment Solutions—EMEA Manager—Multi-Asset Income Management
Strategies
Endnotes
1. Source: MSCI China Net TR USD Index relative to MSCI ACWI Net TR USD, as of July 31, 2021. Indexes are unmanaged and one cannot directly invest in them. They do not include fees,
expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
2. Source: Macrobond; MCSI Total Return USD Index. March 2020 through August 17, 2021. MSCI makes no warranties and shall have no liability with respect to any MSCI data
reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Indexes are unmanaged and one cannot directly invest in them.
They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
3. Source: MSCI ACWI Total Net Return USD. Year-to-date return through August 17, 2021.
4. Source: Macrobond; MCSI China Net Total Return USD Index February 2021 through August 17, 2021. MSCI makes no warranties and shall have no liability with respect to any MSCI
data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Indexes are unmanaged and one cannot directly invest in them.
They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
5. Sources: Macrobond, BIS as of July 31, 2021.
6. Source: Reuters, “China short-term rate hits near 6-year high on holiday demand, policy tightening worries. Reuters,” January 26, 2021.
7. Source: The Economist, “Xi Jinping’s assault on tech will change China’s trajectory,” August 14, 2021.
8. Source: US Centers for Disease Control and Prevention, “Delta Variant: What We Know about the Science,” August 19, 2021.
9. Source: Agencia EFE, China has fully vaccinated 55% of population: government, August 13, 2021.
10. Sources: USA Facts, US Coronavirus vaccine tracker, as of August 16, 2021. European Centre for Disease Prevention, COVID-19 Tracker, as of August 18, 2021.
11. Sources: The New England Journal of Medicine, “Effectiveness of an Inactivated SARS-CoV-2 Vaccine in Chile, July 7, 2021. BBC News, “2021 and Covid: What do we know about
China’s coronavirus vaccines?” July 13, 2021.
12. Source: The Washington Post, “New restrictions sweep China as officials race to contain delta outbreak,” August 3, 2021.
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