What Prompted China's Regulatory Crackdown?

The damage inflicted by China’s regulatory crackdown is still fresh and many investors are wondering whether or not they should abandon Chinese stocks or if the country’s once-beloved tech and internet names are now on sale, offering opportunity.

The Invesco Golden Dragon China ETF (PGJ), which tracks the NASDAQ Golden Dragon China Index, may hold some clues. PGJ slid almost 13% for the month ending Aug. 9 – a reflection of its 78% weight to consumer discretionary (internet) and communication services stocks.

For investors sensing opportunity in these beaten-up names and PGJ, it pays to understand the source of Beijing’s ire. The Chinese Communist Party (CCP) previously block Alibaba (NYSE: BABA) – a major component – from rolling out the Ant Group initial public offering, indicating it was taking a harder stance on internet companies. Things took a dramatic turn when the CCP targeted for-profit tutoring firms.

“Currently, it is very expensive for Chinese families to utilize tutors to help their children perform well during their compulsory years of education, but many families view it as a necessity to help their children succeed academically and be accepted at a highly regarded university,” writes Invesco Chief Global Market Strategist Kristina Hooper. “The Chinese government recognizes that this places a significant and unfair burden on families – and may be a hindrance to China’s goal of encouraging couples to have larger families.”

However, the CCP is looking at other issues – many of which are being scrutinized in the name of improving consumer outcomes, protecting consumer data, and bolstering competition. In the long run, which is the CCP’s preferred timeline, those could be positives for investors, but over the near-term, well, the results speak for themselves.

“Data security is an important issue for all companies and consumers, but countries have done little to protect data. Chinese policymakers believe data security is a national security issue, and as such, do not want foreign entities to have access to Chinese companies’ data,” adds Hooper. “Authorities are concerned that some companies may gain an unfair ability to set higher prices because they control an industry. They also want to ensure that smaller businesses are not at a disadvantage when competing.”

If there’s a silver lining for investors, it’s that some PGJ components may have been unjustly punished and some may sport attractive valuations.

“My takeaway from this situation is that many Chinese equities, especially Chinese tech companies, have been unfairly punished by investors as a result of recent regulatory actions. However, that has created more attractive valuations. As of July 30, the trailing price-to-earnings (P/E) ratio on the MSCI China Index is 18.86, which compares favorably to that of the MSCI World Index at 26.07,” concludes Hooper.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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