By Thomas A. Martin, CFA, Senior Portfolio Manager
The offshore Chinese equity markets have been walloped. The Hang Seng (Hong Kong) index has declined -17.9% from its high on February 17th through September 17th, the iShares MSCI China ETF (MCHI) is down -28.9%, and the KraneShares CSI China Internet ETF (KWEB) is down -52.7%. While China’s weight in the MSCI All Country World index is shy of 4% (versus ~59% for the U.S.), its proportion of world GDP is closer to 15% and nearly even with the U.S. The influence that China has on the world is better thought of in terms of its GDP than its underweight in the stock index. This is because what happens in China significantly impacts many non-Chinese companies whose value chain (from raw materials to intermediate goods to manufacturing to end markets) touches China. It’s fair to think that China’s impact on the world is larger than its share of world GDP.
The past year has brought profound changes to China’s business landscape and control of the Chinese people. Let’s call it “regulation.” The first salvo was last year’s humbling of Jack Ma and the crackdown on various aspects of Alibaba’s many intertwined businesses and relationships. This was followed by intervention in several Chinese companies’ public stock offerings/listings on offshore exchanges, most notably with regard to data integrity and transfer, and national interests in technology and security. This was intermixed with the U.S. also taking steps to protect its intellectual property and limit or reverse undue dependence on Chinese technology. But that was just a minor start. They were just warming up.
The last couple of months has brought a cascade of new regulatory announcements. From new proclamations regarding for-profit educational/tutoring businesses to rules about how many hours of video games minors can watch, to what views movies can imply, to voice inflections of movie stars, the banning of artists who carry “incorrect political positions”, the encouragement of cultivating a “patriotic atmosphere,” to the beauty industry and cosmetic surgery, to the gambling industry, real estate and rent levels, food delivery, confiscation of music streaming rights, health care and online pharmacies, the liquor industry, non-bank payment apps, social media posts, and ride-hailing, it has become increasingly real that anything and everything can be and possibly will be regulated. But that’s not all.
“Common prosperity” is the new philosophical underpinning of Chinese culture, brought to you by the Xi regime. It’s not actually new this year, but it has now been brought to the forefront as part of China’s new 14th Five Year Plan and the celebration of the Chinese Communist Party‘s 100th anniversary. Premier Li recently revealed that more than 600 million people, or over 40% of China’s population, had monthly income under $140. The idea, ostensibly, is to improve that situation. The foundation, according to Party explanations, is to establish a reasonable distribution system that benefits everyone, facilitate people’s well-being, and promotes common prosperity in a gradual and progressive manner. Sounds nice so far, right?
How do you get there? Make basic institutional arrangements on income distribution and adjust excessive incomes and prohibit illicit income. Um…OK.
And this means? Increased regulatory burden and demands for companies to make less profits, revenue confiscations through suggested “donations” to the common prosperity program, partial nationalizations of companies by confiscating equity, and income redistribution via tax hikes and…confiscation. And you better be on-board and say publicly how much you think this is a really great idea.
Oh. I see.
Some investors have gone so far as to say that China is now “un-investible.” They have backed that up by doing what we do in free markets: Selling. The degree of uncertainty and the probability of loss is just too high to consider it “investing” and not speculation or guessing. Others have said that this will ultimately be a long-term opportunity, with the new regime, like it or not, cleaning house, clearing the decks, and setting the country up to really take advantage of its huge population and improved infrastructure. This basic bull/bear tension, of course, has resulted in increased volatility at a minimum, likely for a protracted period of time. It will take years to work out and there will be lots of surprises, twists, and turns along the way. The downturn in the markets represents a re-rating of risk to reflect this through the lowering of multiples.
China’s economic growth is also slowing. As with many countries, it is not easy to handicap where growth will settle (or when) to some sort of normal level. Shutdowns, re-openings, re-accelerations, and a drastically altered labor and supply chain environment make forecasting a challenge. The data has been disappointing and on the soft side lately, and China’s central bank, the Peoples’ Bank of China, seems to have been worried enough to cut some rates and increase stimulus. The markets have also been trying to factor in the immediate and knock-on effects of the Evergrande credit crisis both on a standalone basis but also in the context of China’s huge debt pile with significant intermediate-term repayment/refunding risk. All told, there’s quite a bit to digest.
Our direct China positioning remains underweight. We currently believe that the return possibilities are not worth the risk and we are maintaining minimal exposure. We have not written China off, however, as permanently un-investible, and as part of our ongoing investment process, continue to look for opportunities.
Source: FactSet, Conerstone Macro
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