China's stock market will bounce back in 2022, but expect green energy, not big tech, to lead the way

After such a strong year in 2020, Chinese stocks had a dismal 2021. Battered by changes in regulations on internet and education companies, as well as the continuing China Evergrande saga and concerns about outbreaks of the coronavirus, the MSCI China Index is now down more than 20 per cent year-to-date and drastically underperforming both major developed and emerging market indices.

Further drops for both old and new economy stocks in China could come yet as these factors continue to play out, with questions around whether China is still investible.

I would argue that such concerns are overblown. Chinese stocks may bottom in the first quarter of 2022, but they could also become some of next year’s biggest winners.

The Chinese government’s regulatory changes did initially dampen consumer confidence. In the height of this news story during the summer, I visited Shanghai and saw that normally bustling shopping malls, housing education centres, retail shops and restaurants were empty, despite the country mostly resuming life as normal.

It is also true that one cannot predict the pace, scale, or even content of the regulatory roll-out, making such abrupt changes very difficult for equity markets to digest.

But we should also remember that the regulations are being made for the right reasons. Some Chinese internet companies were getting too big and possibly misusing the data being entrusted to them by citizens and cross-selling unwanted products to them. Introducing regulations to curb certain bad behaviour may disrupt business models in the short term, but in the longer term, such changes are good for corporates overall.

Consider Europe and the US where similar attempts are under way to better regulate the tech industry. Like Tencent and Alibaba, albeit not on the same scale, Facebook’s parent company Meta has intimate access to personal details and lives of nearly half the world’s population, much of it fed through algorithms that have been accused of sometimes sharing false, if not harmful, content and advertising.

Solutions to these problems in both China and the rest of the world cannot be achieved overnight. Markets need to internalise expectations that new regulations will be introduced and negotiations over the boundaries of their business models will play out for a long time, but that ultimately this is all for the common good.

After a turbulent 2021, Chinese tech giants like Tencent will need to adjust to new government regulations to see their stocks recover in 2022. Photo: Reuters

With these developments still ongoing, it seems likely that, as the Chinese government looks set to diverge from the rest of the world on monetary policy and stimulate its economy in 2022, it will not be tech stocks that will lead the expected rebound in Chinese equities next year.

To set the scene, markets in China are desperate for liquidity after the events of 2021. The decision by the People’s Bank of China to cut the reserve requirement ratio in December has been interpreted as a sign that China is beginning an easing cycle that could see credit conditions relaxed yet further – and perhaps a slowdown in the roll-out of new regulations – amounting to a mini quantitative easing that would support risk assets.

With the US Federal Reserve looking increasingly hawkish in the face of rising inflation, Chinese stocks look set to outperform their US counterparts.

Typically, Alibaba and Tencent would come to the fore, and with valuations beaten down, it can seem like a tempting trade. But price aside, the uncertainty around regulations and growth boundaries makes it difficult for investors to come up with reasonable growth assumptions about these companies.

So, who will lead the rebound? The year 2022 could see two groups of stocks do well. Firstly, given China’s push for carbon neutrality and its reinforced commitments at the COP26 climate change summit in Glasgow, companies have much greater buy-in for reaching net-zero carbon emissions.

Thus, expect companies focusing on emissions reduction, new forms of energy, and providing the infrastructure for new energy facilities to be among the market leaders next year.

Given ongoing supply chain bottlenecks, which could very well persist with the emergence of the Omicron variant, Chinese companies providing the technology or equipment to help the country mitigate bottlenecks or do import substitutions could also emerge as major winners.

This could particularly be the case if a worst-case scenario occurs in which Omicron proves resistant to vaccines and causes prolonged lockdowns around the world. Such a situation would likely see China stick firmly to its zero-tolerance strategy and remain closed off to the rest of the world.

Lei Wang, CFA, is a portfolio manager and managing director at Thornburg Investment Management