China matters – it’s a sentiment with which few savvy investors would disagree. Whether it’s capital flows, geopolitical issues, the world’s largest addressable consumer markets, or simply its outsize effect in institutional benchmarks, discussion of China and its prospects for the immediate and long term loom large in any investment strategy.

China’s key attraction is its enormous domestic market. But as the world’s second largest economy, China is deeply interconnected with the global economy in manufacturing supply chains and is increasingly a large portion of multinational corporate revenues. Understanding and navigating the complexities of China has important implications for both domestic and international investing in understanding the development of its capital markets longer term.

The framework for investing in China has changed significantly over the past year due to micro, macro, regulatory, and geopolitical factors. China is still investible, but at the right price in the right sectors. Future potential sources of solid returns could be quite different than in the past decade.

The Risk Premium Is Higher

We’ve been significantly reassessing China’s risk premium, given slower economic growth, rising demographic headwinds, and the potential for further regulatory measures. The country is undergoing a structural change during a cyclical downturn and it could take some time to fully understand the impact of the government’s common prosperity agenda for the economy and President Xi Jinping’s priorities.

From our perspective, China’s economic challenges are fairly apparent: aging population, significant debt at state- owned enterprises and local governments, pollution, wealth disparity, and inefficient allocation of capital. The property sector and its current downturn are of concern and though not believed to be systemic risk, is also part of the structural changes targeted by the government.

President Xi is trying to reshape China’s economy with reforms and regulations. With China’s presidential two-term limit removed in 2018, Xi is widely expected to be elected for a third term at the 20th Party Congress in late 2022, providing more time to implement his agenda and shape China for decades to come.

For now, it means companies with excessively high profit margins may come under scrutiny, similar to what happened in the for-profit education and technology-related sectors. It also means incorporating a much more layered and complex analysis from a fundamental perspective and through a policy lens to see where it fits in Beijing’s development agenda. Examples include companies that are beneficiaries aligned with Xi’s mandate to source locally and develop internal domestic supply chains.

It further means applying a higher risk premium to Chinese equities with comparable businesses to listed stocks in other countries that don’t have the same political risks, such as emerging internet platform companies in Southeast Asia and Latin America.

Over the past 18 months, we’ve become more selective and have narrowed exposure in China. Holdings have become increasingly concentrated in fewer larger positions and in companies run by private entrepreneurs, where there remains potential for secular growth with some political tailwinds.

We’ve become more valuation sensitive and focused on capital allocation, resulting in a reduction in technology holdings and China exposure overall. China’s technology companies have tumbled since early 2021, shortly after China’s regulators abruptly postponed the initial public offering of Alibaba affiliate Ant Financial.

A Focus on Domestic Companies

Finding areas to invest alongside the priorities of China’s government has taken on even greater importance. The government seems determined to prevent private companies from having disproportionate influence on any single area of the economy or to reap high profits at the expense of consumers, although pressure remains for innovation and domestically sourced materials.

It seems the playbooks for large inter- net platform companies have changed and their exponential growth will be more measured. To some degree, this is now reflected in their stock prices. It’s become clear the government wants to prevent the large technology companies from aggressively expanding horizontally into multiple lines of business. Similarly, the government is seemingly protecting smaller competitors to force more equitable distribution of wealth.

In our view, political investment risk may be reduced by focusing on Chinese domestic-oriented companies aligned with Xi’s policy priorities (i.e., automation, local technology and content, environment, electric vehicles (EVs), healthcare) that serve to improve lives at reasonable prices and margins. Many smart entrepreneurs in China have quickly scaled up their businesses and we believe such investment opportunities remain in the country’s large addressable markets in areas like consumer products, healthcare, IT services, semiconductors, and clean energy. We believe it is possible to enjoy a long tailwind of growth if you pick the right place to invest.

Potential Areas of Growth

One area of interest is auto dealerships, which are building their brands within China. It’s a basic business but still largely fragmented across China with room to grow, especially in after-sales service. EVs and urban natural gas networks that replace coal are attractive areas that are aligned with the government’s agenda. Given the aging population, automation and healthcare remain areas with long- term tailwinds. Other potential growth areas are national consumer brands in the alcohol and dairy space, which are gaining share and have pricing power.

Given the sheer population size, domestic consumer brands are beneficiaries of many Chinese consumers who are buying their first homes and household appliances to improve their living standards. This middle class continues to grow and remains aspirational. This approach also helps shield some investments from U.S.-China trade frictions.

Expect a Slower Rate of Growth

There is a risk of a prolonged slump in China’s economy. China is dealing with another round of rolling and more stringent COVID-19 lockdowns, which could further constrain already weak consumer spending and a broader reopening of China’s economy. This also may continue to impact global supply chains and increase global inflationary pressures.

The property market, a significant contributor to the country’s gross domestic product (GDP), is in a significant downturn with many heavily indebted real estate developers. Land and home sales have been weak and there does not seem to be much incentive for buyers on projects that might not get finished.

There are likely to be a few interest rate cuts and tax cuts for small businesses, but no big bang measures like those that pulled China out of its 2015/16 slump. At best, in our estimation, Beijing will slowly turn up the stimulus dial each month.

Historically, volatility in China has been a buying opportunity: The problem appears, growth slows, the government cleverly tweaks regulation and policy with more stimulus, the economy stabilizes, and the market rebounds. But it seems the playbook has changed and many of us are waiting to see if more significant stimulus measures happen after the 20th Party Congress.

In our view, GDP growth is no longer a top priority for China’s Communist Party. We are bracing for more volatility and plans need to be more selective about gauging the risk premium for industries and companies. But we continue to look for longer term opportunities amid this market selloff.

Kevin Martino is Vice President of Institutional in Canada for Capital Group. Christopher Thomsen is an Equity Portfolio Manager, while Kent Chan is the Equity Investment Director.