Asia Perspectives: Managing regulatory headwinds in the China equity markets

• We turn more cautious on the China internet sector in view of rising regulatory risks. The accelerating regulatory clampdown on the education and internet sectors has exceeded market and our expectations both in scale and pace. The sharp spike in policy risk premia will likely keep China internet stocks volatile in the coming months
• Deep value is emerging in the China equity markets after the latest sharp selloff. We advise against panic and indiscriminate selling of quality Chinese stocks. We stay invested in China equities with a neutral view due to attractive valuations, positive cyclical recovery outlook and structural growth opportunities under the 14th Five-Year Plan
• To managing regulatory risks, we focus on diversification and differentiated positioning in sectors and companies that are more resilient, defensive and less exposed to consumer protection regulation. We see opportunities in structural winners exposed to technology self-sufficiency, manufacturing upgrade, 5G, automation and green revolution
• Regulatory risks related to tightening US disclosure requirements and the VIE corporate structure may prompt more Chinese ADRs listed in the US to seek for dual-listing in Hong Kong, Shanghai and Shenzhen

Unprecedented regulatory headwinds

Markets were shocked by a series of unprecedented regulatory actions against the education and internet sectors in recent weeks. China's ADR share prices plummeted 18 per cent since last Thursday and lost 26 per cent month-to-date in July, according to S&P/BNY Mellon China Select ADR Index. On 24 July, the General Office of the China Central Committee of the Communist Party and the General Office of the State Council jointly issued the document on "Opinions on Reducing Homework Burden and After-school Tutoring Burden of Students in the Compulsory Education Stage". The new policy includes a mandatory conversion of K-12 curriculum subject-tutoring institutions to non-profit organisations, and forbidding listed companies and foreign capital from investing in the after-school tutoring institutions, including the variable interest entity (VIE) structures that most foreign listed Chinese companies are using. Moreover, off-campus tutoring should include no overseas education courses and no tutoring should take place on national festivals and holidays under the new policy.

The regulatory changes have significant implications on the business models of the after-school tutoring companies and are estimated to shrink the USD100bn total addressable market by 75%-80 per cent as education is now deemed a "public good" in China. The scale and pace of the regulatory clampdown has exceeded market and our expectations. Although the sector is relatively small within the China equity market, the sharp share price correction had spillover effects to other new economy sectors in response to recent new regulatory announcements.

Managing regulatory risks through diversification and differentiated positioning

To manage regulatory risks in the China equity markets, we focus on diversification and differentiated positioning in sectors and companies that are more resilient, defensive and less exposed to regulatory risks of consumer protection. We continue to see attractive opportunities in quality Chinese stocks recommended under our High Conviction Theme of China's Future Society and Technology and China's Green Revolution for their structural exposure to technology upgrade, automation, healthcare innovation and green revolution under the 14th Five-Year Plan. Strong and healthy development of the new economy sectors remains critical growth engine of the Chinese economy under the Dual Circulation Strategy of the new five-year plan. We expect the already regulated sectors, such as banks and telecom, and the sectors critical for the strategic development goals of technology self-sufficiency and green revolution, such as semiconductor, electric vehicles, renewable energies, are less vulnerable to regulatory risks. 

As part of our risk mitigation strategies, we think China equity long-short hedge funds are effective portfolio diversifiers to manage market uncertainties. We believe higher regulatory uncertainties and spike in market volatility would create a favourable environment for equity long-short hedge funds to capture alpha opportunities in the China equity markets in uncertain times.