Strong Policy Support
China was not a pioneer in renewables or electric vehicles, as both technologies originated from the West. However, the Chinese government was determined to be independent and self-reliant in core technologies. Over the past decade, supportive policies were introduced to drive the development of solar, wind and electric vehicle sectors. What does it mean for investors? Renewables and electric vehicles (EV) stocks have pulled back sharply over the past year as investors de-risked on expensive valuations and sold positions alongside the broader market decline. While the overall sector may still take time to consolidate, we now see value emerging in some names.
Renewables and electric vehicles are likely to receive among the strongest policy support from the Chinese government. In our view, the current policy push serves two purposes. On one hand, the investments in solar and wind power as well as subsidies in electric vehicles can be seen as part of fiscal stimulus to boost economic growth. On the other hand, accelerating green infrastructure investments also takes the country closer to the goal of carbon neutrality. That said, tight financing of the government and weak consumer demand may pose some constraints to the positive impact. Similar green initiatives from global governments may benefit Chinese companies as well, given their dominance in the supply chains. While Chinese companies may likely face stronger competition in the oversea markets from US and European peers, we believe the former may maintain some cost competitiveness in the near term.
Cleaner China stocks as a homogeneous group
Until recently, investors have traded Cleaner China stocks as a homogeneous group to express their views on the broad-based outlook of renewables and electric vehicles. However, we expect increasing divergence within the theme as fundamentals of individual segments are increasingly different. In particular, technological innovation may be a bottom-up driver of stocks and segments this year and next. As the overall market sentiment stabilises, emerging new models in solar cells and breakthroughs in electric vehicle batteries should drive strong performance in stocks with relevant exposure. Looking farther out, autonomous driving may yield the next set of investment ideas in the coming few years.
Investment focus: re-balancing profits in the supply chain
Another investment focus within the Cleaner China theme is re-balancing of profits along the supply chain. In the past two years, upstream players have captured a large part of the value in a solar panel or an electric vehicle as polysilicon and lithium prices have continuously risen given supply shortages, while downstream manufacturers have been much less profitable. That said, we believe the competitive landscape in the upstream may be changing. For solar, we view that the polysilicon price will peak out eventually as new supply kicks in, resulting in a relief in cost pressure and improvement in margins in the mid-stream players. For EV, we acknowledge the risk that lithium may stay expensive for longer, but margins of downstream EV makers may hopefully stabilise so long as the worst of supply shortages is behind us. In a nutshell, we recommend investors to buy the dips for long-term allocation given strong and improving fundamentals.
Geopolitics and competition: USA vs China
Given their roles in the global supply chains, Chinese renewables and electric vehicles are subject to trade barrier and geopolitical risks. Solar panels have significant revenue exposure to the western markets. Currently, solar products manufactured in China are subject to several tariffs when exported to the US with variable rates across products.
Tariffs aside, we believe a longer-term risk is whether US or European countries may drive import substitution to reduce its reliance on the China supply chain amid rising geopolitical risks. Chinese manufacturers account for ca 90% of global solar module capacity whereas US accounts for ca 10%-15% of global demand. Currently, the buffer from non-China capacity is small so the US will not be able to reduce its reliance on China solar modules. However, with the latest policy push of reshoring, US may ramp up the capacity in a few years’ time and decouple from the Chinese solar supply chain. As the reliance gradually reduces, more trade restrictions could be imposed onto Chinese solar panels.
Shifting power in automobiles’ supply chain
While the entire Chinese EV industry is enjoying tailwinds of government support, we have noted a divergence in parts of the supply chain in the shift from the traditional car market to the EV market. EVs are not spared from geopolitical issues. Some EV makers have been relying on the central processing unit (CPU) chips of US companies, but we see increasing risks of export restrictions of auto chips after recent announcement of export restrictions on chips for artificial intelligence. Chinese alternatives are not abundant, as most domestic chipmakers still lag behind in technology. Therefore, the impact is significant in the short term if the ban is enacted.
Specifically, to help the automobiles sector to get back on its feet, the Ministry of Finance on 30 May 2022 announced a CNY 60bn stimulus for automobile sales, which entailed the halving of purchase tax on automobile purchase. The scope of the purchase tax cut was also wider than expected by investors as it covers all vehicles sales with displacement capacity below 2.0 litres and a purchase price of not more than CNY 300,000 (excluding value added tax (VAT) when purchased between 1 June 2022 to 31 December 2022.
Competition is the other risk to the investment thesis that we are monitoring. New players crowding into an emerging industry have been a constant feature in China, and both renewables and electric vehicles are seeing this happening. The solar glass industry is a prime example of victims, with overcapacity driving declining margins. Similarly, downstream players of the EV supply chain may experience a greater level of competition because of the growing number of participants, although the low penetration rate of EV may have room to accommodate more players while forcing existing players to continue innovating at the same time. On the other hand, the midstream (i.e., battery manufacturers) could outperform as they are likely to face less competition as a result of their ability to serve the growing number of electric vehicle makers, while also playing a significant role in EV’s innovation.