Equity Insights: China’s ‘Three Mountains’ Spur Market-Moving Regulation

The results of China’s recent Seventh Census were shocking to many, showing a rapidly aging population and a declining birth rate despite the 2016 reversal of the nation’s one-child policy. With labor shortages adding to concerns about the census findings, the government recently raised the number of children allowed per family from two to three. But difficulties posed by the “Three Mountains” – education, healthcare, and housing – are causing many younger people to think twice about starting or growing their families. In response, the government has introduced a raft of regulatory changes aimed to raise the birth rate and reverse the demographic trends, resulting in a beating for stocks in the education, property, and healthcare sectors.

We view the cascade of new regulations not as a sudden, retrograde move by the government (seemingly the dominant market perception) but rather as part of a continuum of policy reform that has been in place for several years. While the economy has been largely market-driven over the past four decades, China has been pushing for greater regulation (akin to what is commonplace in advanced economies like the US and Europe) since at least the mid-2010s as its economy grew into a behemoth and several industries and companies reached global scale.

What is clearly different in China compared to democratic economies is the lack of lengthy consultation periods with the private sector before a new policy becomes effective – and the more sudden moves have taken equity markets by surprise. China’s equity risk premium over developed markets has risen sharply amid the related uncertainties, and a broad of swath of companies have been caught up in the sell-off. This has created attractive entry points for high-quality companies with strong business models, which have effectively gone “on sale.” The focus on sustainable business models and strong governance also underscores the importance of ESG (environmental, social, and governance) factors in stock selection.

Education: leveling the playing field

A key source of anxiety for prospective parents in China is ensuring a quality education for their children amid fierce competition and concerns about inequities. To address this issue, China recently issued, with little advance warning, sweeping changes to education policy, including strict regulations on the burgeoning private education industry. The proliferation of for-profit after-school tutoring services has contributed to both a heavy cost burden for parents and a widening education gap between wealthier urban centers and less affluent rural areas.

The regulations, which took the industry by surprise, seek to dramatically curb the cost and prevalence of tutoring, forcing these businesses to shift to a nonprofit model and preventing them from advertising or operating during weekends, public holidays, or seasonal breaks. They also ban these companies from raising money through stock listings and prohibit foreign capital investment. Taken together, the new regulations have caused public stocks in the sector to drop precipitously.

Healthcare: cutting costs while broadening access

Another burden for prospective parents is the cost and availability of quality healthcare. China's General Office of the State Council in June announced planned reforms of its medical and healthcare system this year, including efforts to expand availability of high-quality healthcare resources and distribute them more equitably, especially in rural areas. It also aims to continue lowering the cost of prescription medications by promoting generic drugs and bulk-buying programs. Enhanced medical insurance and aid for major diseases, as well as construction of public medical consortiums, are also in the offing.

While public hospitals still provide the lion’s share of care in China, private services have gained a significant foothold. Fears of increased government focus on healthcare regulation caused a steep sell-off of healthcare-related stocks in late July and continue to have investors on edge.

Housing: reining in skyrocketing property costs

High housing costs are intimidating for many young people in China and pose a big obstacle to efforts to encourage family-building. Recent government measures aim to prevent housing prices from rising (or falling) precipitously and to keep price moves more in line with average inflation. These include steps to crack down on speculation and the central bank’s recent order to banks to raise mortgage rates for homebuyers in some big cities. Other actions include steps to rein in leverage for property developers, which has become a growing concern among investors and creditors alike, and to promote construction of affordable housing (including rental housing).

Key investor takeaways

Sharp price declines in China’s “Three Mountains” sectors have also driven up risk premia in other sectors, such as technology and industrials. This has created strong entry points for high-quality companies with strong business models that add social value and bring economic growth to China.

We believe that once markets overcome their initial surprise, they will come to accept the new regulations when viewed through the lens of sensible policies that lead to long-term sustainable growth and social welfare, as has been the case with similar policy reforms in the past. However, in terms of equity investment, due diligence is especially important. We believe it’s critical now to buy only those companies that fulfill societal needs and evidence strong governance and leadership – a good case study for skeptics as to why ESG issues matter in stock selection.

For more equity insights, see our 2021 Midyear Equities Outlook: Hot Capex Summer.