How does the Active Quantitative Equity (AQE) team’s model-driven, systematic approach to investing cope with idiosyncratic market events like the managed collapse of the Evergrande Group in China? We’re glad you asked.
Stock, Sector, and Market Risks
The more concentrated a portfolio is, the higher the exposure to single-stock risks. At AQE, our portfolios’ convictions are expressed in terms of the broadest possible exposures to the characteristics we like, which limits single-stock risk as much as possible. Therefore, what happens in a single stock like Evergrande would typically not be a material concern for a portfolio as a whole, as long as the follow-on effects are limited.
Unfortunately, though, in this case the market reaction to the Evergrande crisis became more about how the default on the company’s debt would impact other companies and the Chinese economy more broadly. The direct effects of default could undermine, for example, other real estate companies, banks that lend to real estate companies, and materials companies that sell cement/steel/copper to the real estate sector. An indirect, follow-on effect might be a slowdown in the overall Chinese economy due to the property market’s large share of total China GDP.1 We see the latter as unlikely because, from an asset allocation perspective, there is good evidence that the Chinese government has all the tools at its disposal to contain the debt crisis and prevent widespread losses; therefore we aren’t exiting the China equities we own.
China Real Estate, Banking, and Materials
Regarding potential direct effects to China’s real estate, banking, and materials sectors, our model-driven view is guiding our investment in these sectors in the following ways:
Real Estate. While many Chinese real estate developers appear cheap, investor sentiment had already been capturing concerns about these names (including Evergrande) prior to the crisis; sentiment started meaningfully declining toward the end of 2020. As Chinese authorities began to put the sector under more scrutiny for being over-levered, analysts recognized that many developers were breaching the government’s “red lines” on net gearing, enterprise value/interest expense, and cash balances.
Quality factors have also been cautious on the real estate sector in China, as some of the balance sheet metrics we use to measure management quality and profitability have been flashing yellow. In our emerging markets (EM) portfolios we have been increasing our underweight to the Chinese real estate sector over the last twelve months.
We see better opportunities to maintain exposure to the broader real estate sector in markets such as Thailand and the United Arab Emirates, where the names aren’t quite as cheap but look much more attractive from a sentiment and quality perspective.
Banks. Also cheap relative to other industries, we’ve observed a decline in the quality level of banks in China since the start of the year. Sentiment toward the sector has only started to decline recently. Twelve months ago, our positioning on the China banking sector was slightly above market weight, but we sold to underweight during the second quarter.
Over the same period our models were presciently diversifying our exposure to EM financials by increasing an overweight to the banking sectors in both South Korea and Taiwan. At the stock level, some names here tend to offer a more robust alpha signal, with a much better outlook from both a sentiment and quality perspective. From a macro perspective, South Korea and Taiwan have less exposure to negative ripple effects from Evergrande and to other idiosyncratic events that have weighed on Chinese equities.
Materials. The impact of a China real estate slowdown on the materials sector probably won’t be limited to Chinese materials companies; it will have global impact. That said, we have had an improving outlook on materials globally, both in terms of sentiment and quality indicators. This sector isn’t particularly cheap, so our overall view of it is neutral. We have some exposure to the sector in both developed and emerging markets and will continue to monitor rising risks and shifts in sentiment measures.
In China, our materials exposure is slightly overweight. Twelve months ago, Chinese cement stocks looked quite attractive. Over the last year quality and sentiment metrics on Chinese cement manufacturers have declined precipitously, and the model has been diversifying into steel producers in India, which are less directly impacted from a slowdown in the China property market.
Figure 1: AQE Model’s View on China’s Real Estate, Banking, and Materials Sectors
The Bottom Line
AQE has a negative view of the quality of both the China real estate and banking sectors, so we will not be looking to take advantage of depressed asset prices there. We will be careful of the materials sector and will keep a close watch on sentiment and quality indicators there, looking for signs of a global knock-on effect of a Chinese real estate slowdown. In sum, idiosyncratic events like the Evergrande collapse actually give us more confidence in our investing approach, as AQE’s models have proven to be adept at identifying market imbalances and responding quickly to warning signs. Lastly, our portfolios’ exposure to the characteristics we like, rather than the names that are in favor, serve us well in these times.
1China’s 2020 Fixed Asset Investment in real estate was RMB17.25tn, or 17% of nominal GDP. Source: Bloomberg, as of December 31, 2020.
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