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By Kunjal GalaPortfolio Manager, Federated Hermes (SubAdvisor)

London - In recent weeks, concerns over missed bond payments by Evergrande Group, a giant property developer in China, unsettled global financial markets. Although Evergrande has now obtained a three-month extension to pay a defaulted bond, China's realty market is reeling as more companies default and bond prices slip.

So far, China's government has failed to directly intervene but is working behind the scenes to limit the fallout, encouraging the country's banks to ease credit and prop up the faltering property sector. Failing a decisive policy response to resolve the Evergrande issue — including a liquidity injection by the Chinese regulator the People's Bank of China (PBOC) — we expect this spill over effect and near-term volatility in related property, insurance and banking sectors to continue. This trajectory is likely to further dampen investor sentiment and amplify the negative wealth effect from weakness in the stock market.

How far will the spillover reach?

We believe the government and the PBOC are likely to make Evergrande an example for other leveraged borrowers. In our view, this approach could hamper the cash flow of weaker developers, cause property price corrections and amplify risks in other parts of the economy.

However, we think Beijing is unlikely to let property prices correct significantly (i.e., in the range of 15%-20%), given home ownership in China is high, and property prices represent a significant part of individual net worth. Moreover, the property sector constitutes approximately 25%-30% of GDP (including the allied upstream and downstream sectors). A significant correction in property prices would likely hurt the "common man" and China's "common prosperity" agenda.

Property deleveraging — along with the ongoing regulatory clampdown across a few sectors (internet, health care and education) — will likely slow down the Chinese economy. While this is negative in the near term, we believe the economy will be positioned for sustainable growth over the medium-to-long term, as systemic issues are resolved gradually.

Obstacles and opportunity

Regardless of our concerns around China, we are seeing two types of opportunity now. First, we see significant value in sectors that have been hard hit by the recent regulatory crackdown, including technology and e-commerce. Second, we think opportunities are bright in sectors aligned with Chinese policies, including decarbonization and localization of semiconductors, biotechnology and automation.

Although there is no shortage of interesting investment ideas, it's also true that we don't expect to see the excessive returns or margins of the recent past — something we are factoring into our terminal value calculations and models.

Within technology, we are focusing on business-to-business (B2B) technology and biotechnology, as we believe these areas are less exposed to regulatory risks and align with the Chinese localization and self-sufficiency agenda. Taking a longer view, we think growth areas such as electrification, hydrogen, cyber security, e-commerce and biotechnology are attractive.

Though regulatory headwinds for e-commerce companies may last for some time while China pursues its "common prosperity" agenda, we believe it is imperative for China to cultivate its internet industry to ensure that the country does not fall behind the U.S. in strategic areas.

While the ultimate impacts from Evergrande remain to be seen, on the whole, we think the regulatory issues are transitory and many companies in e-commerce and other targeted sectors will be able to navigate these headwinds.

Bottom line: Although China's regulatory clampdown and realty woes may leave investors wary, we think China's market holds opportunity from a medium- to long-term perspective. We think the current market sell-off presents opportunities to add to current positions or acquire new ones where we think the risks are well reflected in the price.