A new policy environment is spurring a sense of optimism at Fonds de reserve pour les retraites (FRR), France’s pension reserve fund.

Executive director Olivier Rousseau, a long-time critic of grindingly low bond yields which he has called a “tragedy” for pension funds, particularly those forced to hold them due to regulatory conditions like FRR, can’t hide his enthusiasm for today’s environment of higher interest rates and fiscal tightening after a decade of financial repression.

For years, bereft of any returns, government bonds had become a volatility reduction tool or insurance in a risk-off climate, forcing investors to hunt for yields with lower quality fixed income. Elsewhere, it led to strategies that have now been exposed as risky, particularly hedging liabilities via LDI. Late last year many UK pension funds, prevalent users of the strategy, had to sell assets to raise cash to maintain the level of leverage needed to ensure they could hedge their liabilities when yields jumped sharply higher.

“LDI was protecting portfolios from the consequences of a further decline in interest rates when interest rates were already absurdly low and needed to go back into normal territory,” says Rousseau, who oversees a portfolio split roughly 70:30 to performance assets versus investment-grade bonds including French government bonds and other euro- and dollar-denominated bonds, plus unlisted assets.

Elsewhere he flags another risk area revealed by rising rates: “zombie” companies that have borrowed too much and will start to feel the shock of higher borrowing costs.

The long-awaited policy reset (after many false starts) means monetary policy is returning to normal. Interest rates are edging higher and fiscal policy has tightened, preventing governments indulging in binge borrowing because it now costs money to borrow.

The policy reset means that equities and bonds are an important source of diversification once again. “The arbitrage between interest rates and equities is back. We are in a normalised environment in terms of the policy mix,” he continues – although he cautions that a traditional 60:40 portfolio is still vulnerable to inflation.

If inflation surprises on the upside, investors will lose money on both equities (at least in the short term) and bonds.

“60:40 is a portfolio for a stable inflation regime or a modestly deflationary regime,” Rousseau says.

The new policy environment is feeding into strategy tweaks. For example, come the supervisory board’s asset allocation review in June, Rousseau notes a case for somewhat reducing FRR’s equity allocation in favour of high yield bonds, an allocation he calls something of a sweet spot.

High yields bonds are not overly vulnerable to inflation, and give a decent pick up over sovereign bonds, comparing favourably to investment grade credit. “The spread of high yield over investment grade more than pays for expected credit losses,” he says. Moreover, the lower duration of these assets also gives protection if inflation surprises on the upside.

Cashing in

Like many investors, FRR’s 13 per cent allocation to illiquid investments has provided some of the best returns in recent years. The portfolio has a French bias and includes investment in small-and mid-cap companies and French real estate. Built up slowly since 2013, and mindful of FRR’s liquidity constraints, Rousseau says last year the portfolio truly came right.

Recently FRR’s GPs have started to sell some individual stakes in the €1 billion private equity portfolio at significantly higher prices than where they had been valued, suggesting they had marked valuations at reasonable levels.

“It wasn’t a question of barking up the valuations and praying for validation,” he says, attributing success to good cooperation between the investment teams, management, and the governance. Will private equity continue its run? He says a small reversal this year is possible however if it happens, it will be limited.

Elsewhere the infrastructure portfolio has garnered stellar returns, also buoyed by a few sales. FRR’s small allocation to real estate (around €200 million) has also provided a steady return and the unlisted debt portfolio (€1 billion) returned a positive result. “This is good when you compare this to listed bonds which fell by 13 per cent,” he says.

“It would have been even better if we had succeeded in convincing the governance that there was also a strong case for select hedge fund strategies and insurance-linked strategies,” he reflects.

De-coupling

The policy reset may be fanning an easier investment environment, but Rousseau is mindful of key risks of which geopolitics, manifest in the increasingly fractious relationship between China and the west and ongoing war in Europe, is one of the most perilous. Mostly because of the challenge of finding protection and shelter for the portfolio if geopolitical tension snaps higher.

“Our portfolio has been constructed on the basis that all hell doesn’t break lose,” Rousseau says.

“Except, to some extent, holding US Treasuries and of course tail risk protections which are very expensive, there isn’t much you can do to protect equities and bonds if the Hormuz Strait is on fire,” he says, referencing one of the world’s most important trade routes. Adding, “geopolitics does not matter, except when it does. And today it’s not just neutral – not just noise.”

Positively, it is leading to investable trends (witness Apple’s boosted manufacturing operations in India, for example) that he says will bring increasing opportunities.

“Tapping into deglobalisation trends has very good days ahead of it,” Rousseau says.

And deglobalisation doesn’t mean that everything will be re-shored, he adds. Rather it means companies will build supply chains in countries they deem reliable and friendly.

Because FRR delegates to managers, the investor has no bearing on the day-to-day translation of these concerns on portfolio composition.

“I hope most of our managers are reducing their vulnerability to de-globalisation trends and adapting their portfolios to more recognised supply chains,” Rousseau says.

By law, all FRR’s allocations are managed externally either via mandates (around 80 per cent) or a subscription into collective open, or closed end funds.

Decarbonization

Rousseau’s other enduring concern is the lack of policy action around climate change.

“Governments must stop procrastinating. Policy action is coming, but it is coming too slowly,” Rousseau says, calling for regulation and carbon pricing that means it costs money for investors to hold polluting assets.

Rousseau says he is most encouraged by European disclosure regulation that will require European companies publish their climate exposure at a comparable level to financial disclosure.

“I hope there will be more similar initiatives in the rest of the world,” he says.

“This disclosure will reveal the big losers when the price of carbon finally goes up for real.”

Bad ESG premium

So far, 40 per cent of the equity and bonds allocation has been decarbonised and FRR puts additional demands on its managers every time it renews its mandates.

“It will keep coming down,” Rousseau says. However, like many other investors, he is concerned that divestment (without regulation) is leading to less responsible investors profiting from holding polluting assets.

Responsible investors, he says, are selling polluting assets only for them to be snapped up by other investors (hedge funds, family offices, some private equity, for example) not subject to the same regulation or stakeholder pressure.

This cohort of buyers only see carbon assets through a risk lens – and in the current environment “could have a nice run ahead” in what amounts to, in factor-speak, “a bad ESG premium”.

Only disclosure will reveal the true risk of holding these dirty assets, Rousseau continues.

“As long as carbon pricing remains too low, these investors can continue to hold these assets,” he says.

“What they are doing is mostly rational.

“Disclosure to the susceptibility of a hike in the carbon price is so important because these investors will react to this element. Everybody will see the risk picture more clearly.”

Since joining the Connecticut Retirement Plans and Trust Funds (CRPTF) as CIO just under two years ago, Ted Wright has developed a new strategic asset allocation that has bumped up the allocation to private assets, particularly private equity (up from a 10 per cent target allocation to 15 per cent) as well as private credit, infrastructure, and natural resources.

“One of the things that really stood out was that we were chronically underweight risk assets and private assets,” Wright says, reflecting on what he’s changed at the $60 billion portfolio since moving there from the Los Angeles County Employees Retirement Association.

“We have a risk budget to spend, and now we are spending it.

Public equity has been pared back a little, to around 38 per cent of total AUM. Wright has also rewritten CRPTF’s investment policy statement, articulating the key priorities of the investment management office in one, holistic document.

In a nod to his first career in the military (a self-confessed late bloomer, he didn’t enter the investment world until his late 20s) Wright hopes his approach brings as much rigour and certainty to uncertain situations as possible.

“The military’s discipline, rigour, and work ethic taught me invaluable life lessons,” he says.

“It wasn’t a stretch to go from the military to investment.”

Risk mitigation

In another change, CRPTF’s fixed income portfolio now includes an allocation to risk mitigating strategies that comprises investments that focus on volatility, changes in volatility and different parts of the volatility curve as well as other flight-to-quality strategies to provide downside protection. The allocation – still being built out – is designed to provide stability and to have a negative correlation to markets during equity downturns.

“We want to generate outsize returns when equity markets drawdown, but also design the portfolio in such a way that we can be reactive and proactive depending on market conditions,” says Wright.

“Our risk mitigation portfolio is more complex, but the purpose is to have something that punches above its weight class and doesn’t cost us lots of money while we wait for challenging periods. It is a question of us putting money to work in assets that have greater potential for the upside while reducing the downside during turbulent market periods.”

Manager shakeup

The new strategic asset allocation has led to a shakeup in CRPTF’s 156 (as of June 2022) manager relationships. For example, five to seven managers have gone from the public markets allocation as Wright seeks to consolidate exposures and not double-up.

“It may be difficult to outperform in US public equities ahead,” he says.

“Having six managers carry out one strategy may not be the most efficient use of capital.

“We don’t want to take on more manager risk than we need to, and we don’t want to add managers or have managers in the portfolio just for the sake of having another exposure that is identical to something we already have.”

The decision on which managers to axe was made by looking at tracking errors and managers’ ability to generate returns above the benchmark. Elsewhere, he says investment staff assessed mandates based on the extent returns would increase if CRPTF paid less in fees. Bywords shaping the shakeup were simple, intentional and deliberate, balanced by the need to maintain manager diversity.

Wright has also brought an urgency to the process. Approved last year, most of the do-able shift and downsizing in public markets was completed by the end of 2022.

“I’ve seen situations where a fund completes an SAA and three years later, they still haven’t reached their targets and then they are about to begin another SAA,” he says.

“To be effective, you need to be deliberate with some measure of haste.”

That said, new allocations to private markets are more difficult because they involve pacing up over time. Here Wright is focusing on re-ups in private equity as opposed to looking for new relationships. Bigger allocations to infrastructure and natural resources are nearly wrapped up.

“In private markets, if it’s not a relationship we want to maintain, we don’t re-up and just let the allocation roll off the books,” he says.

“We have a good stable of private equity relationships and hence we are more likely to re-up than add new relationships.”

Diversity

Connecticut runs an emerging and diverse manager program under which it targets placing 5- 10 per cent of total CRPFT assets across public and private markets with diverse managers. Under its so-called Connecticut Inclusive Investment Initiative (Ci3) the investor works with emerging and diverse managers according to a structured, tiered framework which allows promising managers to transition to full sized, direct allocations.

But Wright, one of the few black CIOs heading up a public pension fund, reflects on the enduring challenges in this corner of the portfolio: the idea that investors that allocate to diverse managers sacrifice returns – and the availability of quality, diverse managers.

“Public pension funds’ North Star is a fiduciary duty to pay the promised benefits. My take is, we don’t want diversity for the sake of diversity and investors shouldn’t sacrifice quality in the hunt for diversity. We should have more gender and racial diversity, yes, but this does not mean we have to sacrifice quality.”

“Diversity will only improve if we allocate to the women, black or Hispanic-led investment firms that are as good as the other firms we invest in.”

He concludes that the number of diverse portfolio managers setting up shop on their own is an encouraging sign of more high quality firms emerging.  “Diverse portfolio managers are starting their own firms and new managers are bubbling up. It is getting easier, and it will continue to get easier to find those high-quality firms,” he says.

The United Nations Joint Staff Pension Fund, UNJSPF, is clawing back 2022 losses with assets under management currently valued at $82 billion and the fund experiencing a positive return of 5 per cent so far this year.

Robust returns between 2019 and 2021 had swelled the UNJSPF portfolio by 30 per cent to a record high in its 75-year history to over $91.5 billion by the end of 2021. Come 2022, and the ravages of high inflation and ensuing high interest rates impacting the long-term value of bonds and equity, and assets under management had fallen 14 per cent by the end of the year, said Pedro Guazo, representative of the Secretary-General for the investments of the assets of the fund, speaking in a recent UNJSPF Global Town Hall.

Guazo predicted the fund would be back up to $90 billion assets under management in the next two to three years. UNJSPF targets a long- term return of 3.5 per cent and has a 20-year return of 5.35 per cent. Despite the plunge in AUM last year, Guazo said UNJSPF had retained its fully funded status.

“The market value of the assets is way higher than the liabilities,” he said.

Low costs and efficiency compared to peer funds are an important contributor to the portfolio’s health.

“We manage to get the same returns with costs 30 per cent lower than comparable peers,” Guazo said, attributing low costs to the fact around 82 per cent of the portfolio is managed internally.

Around 50 per cent of the portfolio is invested in public equity versus 30 per cent in fixed income. The bulk of the public market portfolios are managed internally apart from an externally managed small cap equity portfolio and a new allocation to corporate bonds.

The global equity allocation is divided into four teams – North America, Europe, Asia Pacific, and Global Emerging Markets – that follow a disciplined investment process, centred on equity screening, fundamental analysis, and frequent dialogue with corporate management teams. The focus is on high-quality companies able to generate stable cash flows, a return on investment above their cost of capital, and the ability to achieve sustainable and profitable growth.

In a recent change of strategy, UNJSPF introduced a new benchmark for fixed income that incorporates a corporate bond component, broadening the pension fund’s asset mix. UNJSPF uses external managers in the allocation as it continues to develop and strengthen in-house capabilities. Over time it expects that the internal fixed income team will progressively assume a larger management of the portfolio as resources and capabilities are added.

 Private markets

Externally managed private market allocations comprise private equity, real estate, and real assets. Strategy in real estate – the portfolio dates from 1971 – is focused on manager selection. UNJSPF invests in over 128 externally managed funds globally.

The allocation target is approximately 50 per cent core “open ended” funds and 50 per cent non-core “closed end” funds. Core funds are diversified by geography and property type, and non-core funds are diversified by vintage year, geography, property type and risk profile.

Real assets, primarily infrastructure but also timber, agriculture, and commodities, are also managed externally.

Infrastructure investment, first begun in 2011, is focused on moderate leverage, strong cash flow yield and a demonstrated track record of profitable realizations.

Private equity, launched in 2010, consists of a select number of externally managed funds and co-investments diversified by vintage year, private equity substrategy, sector and geography.

Democratic erosion, protectionism, inter-country rivalry and economic decoupling will have implications for economic growth and financial returns ahead, warns a recent White Paper from Norway’s Ministry of Finance, guardian of the giant $1.3 trillion Government Pension Fund Global (GPFG).

Both financial and non-financial risk will increase as the economic centre of gravity increasingly shifts towards emerging markets, a trend that is likely to make management of the GPFG by asset manager Norges Bank Investment Management (NBIM) more demanding, warns the paper.

The warning is based on a review, overseen by director of the Norwegian Institute of International Affairs Ulf Sverdrup, who was appointed to assess how international political and economic developments may affect the GPFG.

ESG fallout

Although the report doesn’t suggest making changes to GPFG’s investment strategy it flags implications ahead, particularly around ESG. The paper authors warn that responsible investment may become more demanding in the years to come and flags against creating ESG expectations that will be impossible to deliver.

NBIM invests on the basis that favourable, long-term returns depend on sustainable development in economic, environmental, and social terms, in addition to well-functioning, legitimate and efficient markets. Strategy at the fund excludes individual products (tobacco, cannabis, coal, and certain types of weapons, for example) as well as conduct-based exclusions that encompass systematic human rights violations and severe environmental damage.

Because the fund is invested in several thousand companies, including in countries and regions with different norms and values “it is neither feasible, nor appropriate, to organise the investment management in such a way that the fund can never be exposed to unwanted situations”, the report says.

Still, it warns that the scope for responsible investment may be weakened if an increasing share of financial markets are in states with less democracy, transparency, and freedom of the press. “Expectations, ambitions, and requirements need to be considered from the perspective of such a setting,” it states.

Pushing values

Although responsible investment is important for the legitimacy and reputation of the fund in Norway, it could weaken its reputation abroad, the white paper continues. “Responsible investment activities may be perceived as an attempt at imposing Norwegian values and interests on companies and states,” the report says.

The paper says an increased awareness that the fund may be perceived differently abroad than in Norway is important, calling for “a realistic level of ambition for the ethical framework”.

The authors write that the giant fund must not be used as a foreign policy tool, arguing that caution needs to be exercised to avert any impression that it is. “Other foreign policy channels are more suitable for promoting Norwegian political interests abroad,” they say.

Using GPFG assets as a policy tool would complicate both the foreign policy and the management of the fund, with a high probability of weakening both areas. At the same time, the paper notes that foreign policy decisions may affect the fund, and that decisions in the management of the GPFG may have foreign policy implications even if such decisions are financially motivated.

Oil price

Although GPFG recently reported a return of -14.1 percent, revenues from petroleum activities and the depreciation of the Norwegian krone contributed to an overall increase of NOK 89 billion ($8.6 billion) in the fund’s value last year. However, this is a benefit that is unlikely to continue. “In the years ahead, we must be prepared for the fund value to not increase at the same rate as has been registered so far, and for a potential decline in fund value,” the report says.

The report said that over time, the GPFG has become an ever more important source of funding for government spending. In recent years, around 20 percent of the fiscal budget has been funded by the GPFG, and the share was even higher in 2020 and 2021 due to extraordinary measures during the coronavirus pandemic.

GPFG invests around 70 per cent of its assets in equity, and is able to withstand more risk than an investor with ongoing payment obligations and consequently a shorter investment horizon. The fund can weather stock market downturns without having to divest at an unfavourable time.

Partnering for Impact: Institutional Investors and the Net-Zero Transition

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Key Takeaways

  • China’s economic policy has shifted to growth, COVID-19 restrictions have been lifted, regulatory rhetoric has relaxed and the tone toward the property and private sectors has become more supportive.
  • While we expect China’s growth momentum to improve further in the coming months, a hard-hit property sector, aging demographics and geopolitics remain headwinds to China’s growth trajectory.
  • Long-term themes remain intact and a vast potential opportunity set exists across public and private markets. Investors should be ready to revise their approach to successfully navigate China’s next chapter.

China has reopened. The recovery of the world’s second-largest economy is underway after three years of some of the strictest public health measures globally. An earlier and faster-than-expected departure from zero-COVID policy began at the end of 2022 as major cities abolished mandatory mass testing requirements. Rules around domestic quarantine requirements and inbound travelers eased in January as China welcomed the Year of the Rabbit with Lunar New Year holiday celebrations. The reopening has occurred in tandem with a strong policy shift towards supporting growth by facilitating a consumption recovery and rebuilding consumer confidence, including measures to stabilize China’s property sector. This policy pivot led to a cyclical recovery between November 2022 and February 2023 as sentiment toward Chinese assets improved and fueled one of the best performing three-month periods on record for the MSCI China Index—albeit from a depressed starting point. A nine-day long policy event, the National People’s Congress (NPC), concluded on March 15 with policymakers re-emphasizing stability of growth as a key goal of the government and reassuring the private sector and international business community of Beijing’s pro-business stance. As many aspects of China’s economy and society normalize over the coming quarters, we expect China’s growth momentum to improve. While a cyclical recovery may continue to drive markets in the near term, successfully navigating China’s next chapter will also require public and private investors to refocus on a wide set of new opportunities—and new risks. These include long-term secular tailwinds and structural headwinds with the potential to affect asset class performance and investment portfolios in the years ahead.

Reopening and Recovery

The potential pace and magnitude of a consumption rebound in China this year remains firmly in focus among market participants. Chinese household consumption was ~7% below potential in 2022, implying significant room for recovery.1 If the post-pandemic consumption pattern of other economies leaves any indication, China may see sharp rebounds in discretionary consumer goods and services spending, especially domestic tourism. During China’s Lunar New Year Golden Week (January 21-27), movie box office revenues, postal package delivery, and restaurant sales all exceeded 2019 levels. There was also a V-shaped recovery of domestic air traffic and booming hotel demand. Consistent with the mobility data, China has returned to work with a sense of urgency. Purchasing Managers’ Index (PMI) data came in above consensus expectations in February, with the Caixin Services PMI—the most sensitive part of the economy to a reopening—surging to 55.0 well above the historical mean of 53.7.2 We believe China’s reopening has the potential to trigger a consumption revival in 2023 led by a release of pent-up demand, improvement in the labor market and incomes, and a broader recovery in consumer confidence. However, it is still too early to tell how robust and durable China’s economy will be, and three years of zero-COVID policy and eighteen months of property sector stress have left scars that could hinder a broad-based consumption recovery. For example, elevated unemployment rates among China’s 16-24-year-olds could weigh on the consumption capability of this cohort, even as the recent relaxation in various regulated areas, such as tech and education as well as the more recent recognition of platform companies as national champions and employment generators, provides some support for job prospects and income security. Meanwhile, cumulatively, from 2020 to 2022, excess savings in China—which we define as the amount of savings above what a “normal” pre-COVID savings rate would imply—appear to be relatively small in contrast to other economies such as the US, estimated at less than 3% of GDP or 6% of household disposable income at the peak during the pandemic, though in absolute terms this number exceeds RMB 3tn (~$435bn).3

Along with signs of a consumption rebound, we believe it will be vital for investors to closely monitor global spillover effects from China’s reopening on goods trade, international travel, and commodities. Increased domestic demand in China could boost goods exports from other economies, for example. We expect Asian economies—which account for more than 50% of China’s import demand—to be the key beneficiaries of this growth impulse, though results will vary at a country level. China is the largest export market for most economies in the region, absorbing 50% of exports from Taiwan and Australia, 30-40% from New Zealand, Korea, Malaysia, and the Philippines, and around 20% from the rest (with a notably smaller 7% for India). The distribution of benefits will also depend on which sectors in China experience the strongest growth. Taiwan accounts for a quarter of tech imports into mainland China, for example. Demand recovery in foreign services, particularly for international travel, would additionally provide a modest boost to global activity. Again, Asian economies and some developed markets are likely to benefit if international travel returns to pre-pandemic levels. Higher commodity demand and prices are another channel through which China’s reopening will affect other economies. China is the world’s largest commodity consumer and biggest oil importer, and we expect its reopening to be moderately inflationary due to higher commodity prices. Within China, the unique nature of the post-reopening recovery may result in a mixed inflation picture. Prices of pork, a staple in China, surged in 2022 but may be less of an issue as supply disruptions begin to ease. Durable goods such as autos, smartphones, and computers tend to have long and sophisticated supply chains and are likely to be affected differently by reopening.

China’s reopening and recovery will be closely watched by many investors over the coming quarters. Data suggests hedge funds moved swiftly to rebuild China exposure from November to January. Active mutual funds globally re-risked to a lesser extent. However, by the end of February, Chinese equity funds had recorded steady year-to-date inflows of ~$3.6bn from global mutual fund investors.4 We see large pools of capital that do not have the level of holdings in China that they used to allocate. This implies that net foreign buying may continue in the months ahead, especially given the recent improvement in China’s fundamental outlook. Revenue normalization in areas that have been impacted the most by COVID restrictions may remain a tailwind and could drive further equity gains. The downside risk of maintaining underweight exposure to Chinese assets could therefore be high. We see public market strategies well placed to capture further upside in the near term. These strategies can take advantage of both improving fundamentals and tactical re-rating opportunities in areas where valuations are still suppressed relative to historical ranges, notwithstanding the recent rally. We expect China’s equity and fixed income complex to contain an abundance of alpha generating opportunities for bottom-up, active managers in 2023 and beyond. Many investors still include China as part of a broader allocation to Asia or emerging markets; however, China’s size and the breadth of its equity and fixed income markets could merit a standalone country or incremental regional allocation for investors considering Chinese equity and fixed income exposure. Both China’s A-share market and Chinese fixed income markets boast a strategic investment case for international investors underpinned by their size, liquidity, and diversification appeal.

Beyond Reopening

Despite optimism around China’s reopening and recovery in the near term, we expect headwinds to shape China’s growth trajectory and asset class performance in the years ahead. We examine three key issues in more detail: property sector stress, demographic shifts, and geopolitics.

First, China’s property market remains a key concern. The country’s real estate market stayed soft in 2022 amid continued liquidity and credit stress for developers, even as greater concerns over contagion risks stemming from Evergrande’s default began to abate. More recently, sentiment has further improved as policymakers’ tone towards the sector has turned decisively more dovish. Credit support to both high-quality developers and homeowners has been introduced and we expect more policy easing to come. We have since seen a recovery in both primary and secondary property transactions year-to-date. The long-term policy focus is likely to be on managing a multi-year property sector slowdown, rather than engineering an upcycle. Property developers’ debt-repayment problems have been among the biggest issues affecting Asia’s credit markets over the past two years. More recently, the asset class has experienced a forceful rebound. A recent rally of China property high yield bonds reflected a reduction of left tail risk for the stronger developers. We think stresses and defaults could continue to build and the near-term outlook remains challenging. Even so, we believe there is a potential opportunity for attractive total returns in the deleveraging of the Chinese property sector through active security selection, while recognizing that Asia’s credit markets represent a diverse opportunity set beyond China.

Second, China’s changing demographics will likely present long-term challenges to the country’s growth potential and alter the structure of its economy. China’s population started shrinking in 2022 for the first time in six decades.5 The demographic transformation has led to an increasingly top-heavy population pyramid. China’s old-age dependency ratio (the ratio of the population aged 65 and over to the population aged between 15 and 64) is expected to increase from 10% in 2000 to 41.5% by 2040, according to United Nations projections.6 Although China loosened its family planning restrictions in 2015 to address emerging demographic problems, birth rates have not improved following the implementation of the two-child policy. Even if China were to further relax its birth policies, fertility rates may not increase due to structural factors, including the fall in the number of women of childbearing age—a result of family planning that began in 1980; and improving living standards and education levels delaying marriages and childbirth, and the pressures and costs of parenting. Demographic headwinds are not unique to China. Many countries have increasingly aging populations, but China is already home to the largest population of older people in the world. Investors have opportunities to lean into areas of demographic change. Segments of China’s healthcare sector stand to benefit as aging consumers start to spend a higher proportion of their budget on medical services and less on tangible goods. At the same time, President Xi Jinping has put health and social care at the center of the government’s policy agenda. More broadly, lower labor force participation rates tend to raise labor costs and result in retirees drawing down savings. This may constrain the available supply of capital, potentially creating compelling opportunities for private investors seeking to put capital to work in China.

Third, geopolitical risk remains a significant overhang on Chinese assets. The Russia-Ukraine war raised investor concerns around geopolitical issues, including China-Taiwan tensions and US-China trade and technology frictions. Diplomatic tensions with the US increased at the start of 2023 as the US shot down a suspected surveillance balloon and Secretary of State Blinken postponed his planned trip to Beijing. Strained relations between the US and China appear to have encouraged both to strive for more self-sufficiency in key industries. This may lead to more centralized economic policies where state intervention plays an important role, either directly or indirectly, through incentives and disincentives to decision makers and businesses. The US move to ban the transfer of advanced semiconductor technology to China may prompt Chinese leaders to ramp up state-directed investment in domestic chip producers and bolster onshore manufacturing. This could intensify the race between the two countries for dominance in the tech sector. Elsewhere, Beijing and Washington have also been at odds over access to audit papers of Chinese companies. Since 2021, Chinese offshore initial public offerings (IPOs) in the US have almost ground to a halt. However, February saw the first Chinese company to raise more than $100 million in the US in 15 months as China’s securities regulator eased curbs on overseas IPOs, sparking hopes that Chinese companies will restart their ambitions to list in major markets such as New York.

Geopolitical headwinds and new alliances ultimately create a more uncertain environment that weighs on consumer and corporate confidence. Governments’ fiscal spending priorities may also change, with increased spending on defense and/or more support for domestic industries. Private capital may be advantaged by its ability to provide long-term, patient capital that can respond to long-term shifts, while reacting less to near-term geopolitical gyrations. Private capital can also provide investors with access to a broader selection of industries given the stops and starts in the IPO market. From an FX perspective, global instability is also leading to a desire for greater currency diversification and could give rise to more institutional investor allocations and central bank reserves potentially shifting to RMB and EUR, alongside the dollar. That said, there are still material barriers to a wholesale shift into RMB. For example, foreign ownership of Chinese Government Bonds (CGBs) remains low at around 12%, although we think CGBs continue to offer investors diversification benefits given their low correlation with other assets.7 We also expect structural inflows as a result of increasing weights of CGBs in major bond indices to be supportive for the asset class over the long term.

Secular Trends

Every new cycle has new winners, and in China, picking the right themes and sectors in the right cycle has demonstrated to be highly rewarding. As China enters a new chapter, we believe it will be critical for investors to align their portfolios with long-term secular trends. This may include opportunities that are essential building blocks to—or at least well-synced with—initiatives set to guide China’s economic growth orientation in the decades ahead. China’s Common Prosperity vision, for example, is a concept which we believe represents a growth reorientation where policy support could pivot towards industries that carry long-term strategic value to China, including areas of technology, healthcare, and decarbonization.

Prosperity heavily depends on the ability for China to grow its economy in a high-quality, efficient, and sustainable manner. We believe China will have to develop its internal production capabilities in foundational technologies, specialized equipment and essential materials along key supply chains, such as semiconductors and enterprise software, if it is to improve its global competitiveness and self-sufficiency—especially against a backdrop of elevated US-China tensions. Building out digital infrastructure will also be essential to enable China to reach its long-term growth targets. Digitization will touch most areas of China’s economy, but we believe it could have the greatest impact on the enterprise technology and financial sectors.

Core technology aside, energy security is another necessary condition for sustained growth. While China is the largest producer of rare earth elements critical for energy transition, it is also the largest energy consumer in the world, representing 14% of oil and 52% of coal demand globally. About 73% of its oil consumption and 8% of coal is sourced externally, underscoring China’s heavy dependence on energy imports in areas that could expose the country to national security concerns.8 The word “ecology” has also received significant mentions in many official Common Prosperity reports, and reducing energy pollution is a core component of sustainable development. We believe China’s pledge to reach peak CO2 emissions by 2030 and carbon neutrality by 2060 will continue to underpin its quest for less-polluting energy supplies and enhancing energy efficiency. This could usher in secular investment opportunities centering on renewables (e.g. solar, wind, hydrogen) and environmentally-friendly energy applications, notably electric vehicles and related supply-chain components (e.g. battery technology and charging piles). Policymakers are also increasingly focused on alleviating water scarcity and reducing water pollution.

We believe finding and executing public and private investments in areas that benefit from structural tailwinds will prove rewarding. The make-up of China’s newly born unicorns—privately held start-ups with valuations over $1 billion—is increasingly concentrated in industries that are more aligned with China’s national development goals. In 2022, 70% came from four fields: clean technology, renewable energy, healthcare and smart logistics.9 Economies of scale and industry consolidation have historically been winning formulas in China. Going forward, a focus from policymakers on regulating anti-monopoly behaviors, discouraging cross-sector capital expansion for platform operators, and offering targeted support to emerging companies may strengthen the competitive positioning of small and medium sized enterprises. ‘Little Giants’—emerging companies handpicked by China’s authorities for explicit policy support—are particularly aligned with strategic policy goals. These small/mid-caps are mostly found in capital goods, new materials, technology hardware and semiconductors. These sectors are critical to Chinese national security, growth sustainability, and the Common Prosperity initiative.

New China Playbooks

China remains a large, growing market with a vast opportunity set. But as China reopens and its economy recovers, the country’s next chapter is set to look a lot different than the last. This means investors cannot rely on their existing game plan. As the long-term trends in China shift, it is important to see the change, understand the change, and continue to look forward. We believe investors will need to take a more nuanced view of public market exposures and add thoughtful idiosyncratic exposure to private markets with managers able to identify and execute in thematic areas with structural tailwinds. This could make portfolios more resilient as China enters its next chapter.

Important information

1Goldman Sachs Global Investment Research. China post-reopening consumption recovery: Large potential, lingering scars. As of January 18, 2023.

 

2Goldman Sachs Global Investment Research. As of March 1, 2023.

 

3Goldman Sachs Global Investment Research. China Data Insights. As of February 7, 2023.

 

4EPFR, Morningstar, MSCI, FactSet, Goldman Sachs Global Investment Research. As of February 28, 2023. Morningstar data includes flows across China Equity and China A-Share Equity categories. Past performance does not guarantee future results, which may vary.

 

5National Bureau of Statistics of China. As of January 18, 2023.

 

6Goldman Sachs Global Investment Research. Population Aging, Pension System, and Individual Retirement Savings in China. As of February 10, 2023.

 

7Source: IMF, Goldman Sachs Global Investment Research, Goldman Sachs Investment Strategy Group, and Goldman Sachs Asset Management. As of January 29, 2023.

 

8Goldman Sachs Global Investment Research. Finding the “Common” paths to “Prosperity”. As of October 25, 2021.

 

9South China Morning Post (SCMP). China added 74 unicorns in 2022, maintaining steady pace of growth despite fundraising crunch. As of February 3, 2023.

 

Glossary

 

Alpha refers to returns in excess of the benchmark return.

 

Bps refers to basis points or 1/100th of 1%

 

Correlation is a measure of the amount to which two investments vary relative to each other.

 

Dovish refers to more accommodative monetary policy, the opposite of Hawkish

 

FX is foreign exchange market.

 

GDP is Gross Domestic Product

 

Left-tail risk refers to the risk of unlikely yet extremely negative portfolio outcomes.

 

PBOC is People’s Bank of China

 

Risk Considerations

 

All investing involves risk, including loss of principal.

 

International securities may be more volatile and less liquid and are subject to the risks of adverse economic or political developments. International securities are subject to greater risk of loss as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

 

Private equity investments are speculative, highly illiquid, involve a high degree of risk, have high fees and expenses that could reduce returns, and subject to the possibility of partial or total loss of fund capital; they are, therefore, intended for experienced and sophisticated long-term investors who can accept such risks.

 

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

 

Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.

 

Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.

 

Investors should also consider some of the potential risks of alternative investments:

 

Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

 

Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

 

Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

 

Counterparty risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counterparties will not perform their obligations under such contracts.

 

Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all.

 

Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments.

 

Infrastructure investments are susceptible to various factors that may negatively impact their businesses or operations, including regulatory compliance, rising interest costs in connection with capital construction, governmental constraints that impact publicly funded projects, the effects of general economic conditions, increased competition, commodity costs, energy policies, unfavorable tax laws or accounting policies and high leverage.

 

Alternative Investments – Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

 

Investments in real estate companies, including REITs or similar structures are subject to volatility and additional risk, including loss in value due to poor management, lowered credit ratings and other factors.

 

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital.

 

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

 

Conflicts of Interest 

 

There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

 

General Disclosures

 

Diversification does not protect an investor from market risk and does not ensure a profit.

 

The views expressed herein are as March 28, 2023 and subject to change in the future. Individual portfolio management teams for Goldman Sachs Asset Management may have views and opinions and/or make investment decisions that, in certain instances, may not always be consistent with the views and opinions expressed herein.

 

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security, they should not be construed as investment advice.

 

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

 

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

 

Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

 

Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

 

There is no guarantee that objectives will be met.

 

Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

 

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by Goldman Sachs Asset Management and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs Asset Management has no obligation to provide any updates or changes.

 

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

 

Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

 

References to indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only and do not imply that the portfolio will achieve similar results. The index composition may not reflect the manner in which a portfolio is constructed. While an adviser seeks to design a portfolio which reflects appropriate risk and return features, portfolio characteristics may deviate from those of the benchmark.

 

The opinions expressed in this white paper are those of the authors, and not necessarily of Goldman Sachs. Any investments or returns discussed in this paper do not represent any Goldman Sachs product. This white paper makes no implied or express recommendations concerning how a client’s account should be managed. This white paper is not intended to be used as a general guide to investing or as a source of any specific investment recommendations.

 

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Date of First Use: April 20, 2023.  310270-OTU-1771097