By FAY REN
China’s economic trajectory is a tale of two countries.
The world’s second-largest economy is grappling with an intricate web of domestic growth challenges and external geopolitical pressures, while simultaneously demonstrating remarkable industrial achievements and policy resilience. The bear and the bull narratives are both present, simultaneously. The puzzle exists in the disjoint between, at the sector and company levels, market share and cost advances and their non-replication in stock market returns.
The bearish narratives have been in place since the domestic residential property market entered a downturn in 2021. The resultant deleveraging induced a deflationary spiral, persistently weakening consumer confidence. Further exacerbating factors have been adverse demographics and capital outflows, deteriorating relations with the US and its allies.
These, in sum, have been large enough to mask the advances being made by China’s industrial policy. A closer look reveals that policy is delivering genuine technological breakthroughs whilst reducing its reliance on the US.
What’s more China’s industrial advances are being racked up in scale despite the onslaught of US embargos since 2018. Stop China was a President Biden era initiative that has been continued by President Trump, with the lurking thought that Trump might wish to roll the policy into a big fat bargain and trade it away.
Ten years have passed since the introduction of the “Made in China 2025” initiative. An October 2024 report—authored by the then US Senator, now Secretary of State, Marco Rubio—found that China has already reached or is close to the technological frontier in most of the initiative’s ten target sectors:
“Of the 10 sectors targeted by MIC2025, China can credibly claim to be the world leader in four (Electric Vehicles, Energy and Power Generation, Shipbuilding, and High-Speed Rail); China is therefore shaping up to be a superpower of green energy and advanced logistics.
In five sectors, China has made substantial progress toward the technology frontier but is not yet a leader: Aerospace and Aviation, Biotechnology, New Materials, Robotics and Machine Tools, and Semiconductors.
In just one sector, Agricultural Machinery, has China fallen short of its aims.
If Xi Jinping were a fund manager, he would have every reason to be pleased with the performance of this portfolio.”
Not all the credit should be allocated to the Chinese state, however, as private enterprise has done made much of the running in these sectors. Notably, ‘MIC2025’ predates today’s Generative AI boom, where China is also a credible contender in the AI race, demonstrated by January’s surprise unveiling of DeepSeek (also born within a private enterprise).
Adding to the irony, Washington and Beijing are busily emulating each other’s playbooks. Through the Inflation Reduction Act, the CHIPS Act and a raft of others, the US is reviving the industrial policy that underpinned its post-WWII manufacturing dominance. China, for its part, is attempting to rebalance away from its decades long export-and-investment-driven growth model toward consumption-led growth. It is worth pointing out, consumption has been growing at a relatively healthy clip of 9% CAGR in real terms over the last two decades, but dwarfed by investment, which has grown much faster.
Source: FT, FRED National Bureau of Statistics of China
So why then have Chinese equities failed to mirror the country’s economic achievements? The US equity market has returned 2.5x over the last decade, while China’s meagre +25% return (one tenth of that available from the US) was driven entirely by dividends with zero capital appreciation.
Source: Bloomberg
In terms of explaining the industrial success not replicated in stock market returns, Louis-Vincent Gave of Gavekal points to market structure as an important driving factor.
China is the world’s second deepest equity market (after the US) by market capitalisation. The Shanghai Shenzhen Composite index is capitalised at US$6.5tn. Hong Kong’s Hang Seng Index is capitalised at US$3.5tn. By comparison the market capitalisation of the FTSE All Share is approximately US$3.6tn. The UK is a developed market but do these monikers mean anything anymore?
A relentless supply of new capital via IPOs and secondary offerings has challenged Chinese capital markets, sated appetite and created a zombie class of counters. This has led to the perception, held by professional and retail investors that shareholder returns were never a priority.
The US has affected the opposite. It has folded in on itself. Industrial consolidation has been running for decades: the number of public companies more than halved since the 1990’s. Shrinking share counts via corporate buybacks have magnified per-share earnings. The era of ZIRP (zero interest rate policy) which lasted, broadly from 2008 to 2022, was a tonic for financial engineering. Listed US companies are financially engineered to the core of their selves. Oracle has a negative net asset value (miracolo!). Apple has a reported Return on Equity (RoE) of 154% (splendido!). Add back the shares bought back and cancelled over the past few years and that number drops to a more hum drum 14%.
The other factor that has worked a treat in the US has been increasing market concentration. First came the ‘FAANGS’ to be replaced by ‘The Magnificent 7’. International capital has flowed into the US at extraordinary rates, adding punch to the already strong US dollar.
Interestingly, the market capitalisation ratio between Chinese and US equity markets – despite the performance differential – has remained static since 2007. Which is the better capital market in terms of the textbook definition of capital market? Both inhabit extremes. The really interesting question lies in imagining a reversion. American capitalists stop eating their own companies. Perhaps the next President might remove the tax efficiency of buy-backs. In turn, Chinese authorities help unlock returns by nudging the rules, moving the goalposts; operating the gate to help investors access returns. They could wisely surmise that investors, including foreign investors, should make a buck. That would both enhance consumption at home and encourage (via open market forces) international portfolio investors to re-engage. If the US restricts US domiciled investors, then European and Asian asset managers could benefit.
There are signs that Beijing is beginning to tackle its own set of distortions. Share-buybacks are increasing. A number of other governance reforms are quietly under way to improve the structural sustainability of its equity markets, and improve industry competitive dynamics in general, addressing issues such as overcapacity and destructive pricing.
Source: Wind, Gavekal Dragonomics/Macrobond
Shy of a grand bargain by Trump (which would, in any case, be parsed carefully by Xi and the politburo) there are formidable hurdles to the geopolitical set-up, chiefly in the form of export and technology embargos. That said, China is in a stronger negotiating position than it was in 2018, owing to the industrial resilience built since Trump’s first term. While global (as well as Chinese) companies are diversifying supply chains, the country remains deeply embedded into the critical junctures of global trade such as rare earth minerals and metals. It remains the largest trading partner of every major Emerging Market country bar Mexico, and its trade with ASEAN now exceeds the US.
Currency debates are more polarising. The fundamental tension between capital controls and currency internationalisation remains unresolved, with China balancing a managed exchange rate while seeking broader international acceptance of its currency. This approach runs contrary to conventional philosophy, where capital account liberalisation precedes significant global adoption. The world, broadly speaking, was wrong to think that China would give up control of its currency.
IMF data indicate a glacially slow adoption rate of only 2.4% share of global reserves into the RMB (data from May 2025). However, from a transactional perspective, the RMB has been making inroads in trade invoicing and settlement, through a web of 43 bilateral swap agreements established with different nations over the last 15 years, implying growing utility. Meanwhile, CIPS—China’s alternative to SWIFT—now processes more than a quarter of the country’s cross-border transactions; In April, daily RMB settlements via CIPS surpassed SWIFT for the first time, chipping away at US dollar dominance.
Comparisons with Japan are somewhat forced. China today is a successful exporting economy with an expensive currency and little inflation.
Fierce domestic competition has forged globally competitive companies, not just on cost but increasingly on quality and innovation. Our equity strategy therefore tilts toward domestic substitution as local companies disrupt the status quo, taking share both at home and abroad, seeking growth opportunities beyond US demand—a departure from the old assumption (perhaps taken for granted) that emerging market champions must conquer the US market be deemed a global leader.
We group holdings into three buckets, examples include:
Local substitution:
- Industrial upgrade: Naura Technology (semiconductor equipment), Hengli (machinery & robotics)
- Healthcare: United Imaging (medical imaging), Wuxi XDC (CDMO)
- Software: Empyrean (EDA software), Kingdee (ERP)
Global (ex-U.S.) growth:
- CATL (EV batteries), BYD (EV)
Stratified consumption:
- Anta (sportswear), Tencent (social media)
In respect of wider equity holdings (especially global companies), we are increasingly conscious of the Chinese concept of neijuan. This is translated as involution, the process by where companies compete to the edge of destruction. This has become one of the main features of ‘capitalism with Chinese characteristics’ a phrase attributed to China’s domestic economics but not actually voiced by Deng Xiaoping or those that have come after him.
Involution creates two phenomena: the first is cut-throat competition at home, an extreme Darwinian process that produces one or two winners and many casualties. It purposefully depresses return on capital. The second process is when the winner elopes overseas, hardened and bench-fit and smashes competition in other countries. The Chinese EV maker BYD would be a paradigm example of this phenomenon.
The big question is whether it is more profitable to pursue the shares of the crusher or to spend more time avoiding the shares of the crushed? With our (Western) expensive regulations and labour law restrictions and high-cost bases, there are (statistically) more companies to be crushed then there are crushers to be identified. This poses questions for the equity investor. We identified (above) 10 Chinese companies we commend investment in. Outside China, there are companies and sectors to re-think. There are companies to be sold.
James Spence contributed to this article.
Cover image: PuzzleGarage.com
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