The Great Wall (Of Indifference)

Anti-government protests in China have spread like . . . a highly infectious disease of the upper respiratory tract. This should ring the bell on the recent rip in Chinese equities. Lockdown. Crackdown. Go down.

While the politics and unrest hog the headlines short-term, the dilemma for emerging market funds is a big one. Are the factors undermining Chinese shares transitory and pose merely tactical challenges, or are they more structural and beg the question of portfolio managers: is China uninvestable?

After a one-year drop exceeding 20 per cent the moribund Shanghai Composite has shown signs of life following the easing of monetary policy, measures to relax stifling Covid restrictions and perhaps alleviate the more draconian elements of the regulatory pressure exerted on Chinese companies.

That index, however, doesn’t really do justice to the carnage among the Chinese equities held by international investors. This is better represented by say, the Nasdaq-listed China iShares MSCI ETF which touched $98 in February 2021 before starting a vertiginous decline to a low of $35 this autumn (before rebounding to $47 at pixel time).

There are mounting signs of a strategic shift among big investors. In October the Texas Teachers Pension Fund halved its benchmark weighting for China, citing its outsized weight in the benchmark and a drive for more diversification. But will prove a harbinger of strategic divestment by the bigger EM investors. If replicated by all US public funds, that would generate $89bn of passive outflows from the market, according to analysis by CLSA strategist Edwin Chan.

The severity of the pummelling meted out to Chinese stocks is already hefty. Best-known and well-beloved among international funds, Tencent shed three quarters of its market capitalisation between January 2021 and October 2022. Falls of similar proportions were recorded by the likes of go-to names like JD.COM, Baidu and Alibaba. The top ten stocks in MSCI China and HK had all halved from five-year highs, making the damage to returns almost impossible for international institutions to avoid.

China has been superseded by India as the cynosure of the emerging markets complex. While China’s derating has been sudden and thorough, India now commands eye-watering, premium ratings. China stocks trade at about 5 times 2023 earnings, a massive 74 per cent discount to India, and 45 per cent to the rest of the Asia-Pacific region. It truly is the year of the rat for old China hands.

Russia hasn’t done much for China’s equity risk premium either. Having been written off as uninvestable many times before actually achieving the status, literally and unequivocally, after the invasion of Ukraine, Russia set a precedent for excommunication from the broad church of EM. Xi has made such a big deal of “peaceful unification” with Taiwan that investors are already eyeing the inevitability of Xi’s attempt to reincorporate it into a Greater China during his presidency.

The reasons for the demise of Chinese equities for western investors are multi-faceted. But the financial leper status conferred by markets is not simply a function of economic slowdown, its First-In, Last-Out Covid experiment, the cutting-down-to-size of business magnates and civil disorder. This is short-term volatility and (admittedly loud) noise.

Rather, it’s the shift in the Chinese Communist party’s ideological thinking, overlaid on to well-established demographic challenges, which is fundamentally antithetical to equity market wellbeing. Longer-term motivations to divest are more plausible to EM investors than those justifying a short-term rebound. The clue is right there in the name of the CCP.

The upheaval in President Xi’s priorities from reform and opening, the Chinese variant of perestroika and glasnost (a worrying analogy) towards what’s known as “common prosperity” has been cataclysmic. The interests of the CCP and international equity investors are no longer mutually aligned.

Future reforms are unlikely to be market-friendly. China’s property sector is an obvious target for wealth redistribution. Sustaining high real estate prices seems more dangerous to the Politburo than allowing them to fall. This explains why the price to book of the sector was 1.8 times in 2018 but just 0.8 times now. The sector is entering a long downcycle.

Inflated property values depress investment in other sectors of the economy. The limits of the multi-decade investment driven development model have been reached. China overinvested in property and infrastructure and will now prioritise tech, biotech and the chip war. It’s not clear how international investors will be able to participate here.

After the last two years’ Great Wall of Selling from international investors, China stocks may find themselves contemplating their Great Wall of Indifference.