As Chinese stocks plummet, it’s tempting to want to call this a reprise of past drawdowns in the region, like what happened toward the end of 2015, and be tempted to jump in at “cheap” valuations. But I think it’s different this time.
I believe China’s recent crackdown on public companies hallmarks a major shift in China’s priorities that will have large-scale implications on China that will permanently impact the emerging market and international holdings in your portfolio.
Are you aware of what’s really going on in China?
The Russian Parallel
I’m used to dealing with prickly authoritarians, as I spent my college years in the throes of Russia’s turn to capitalism and democracy and back to authoritarianism. In the 1990s, I was perhaps the youngest independent American in Moscow driven by a desire to understand this different world and this historic economic and political transition.
I hailed gypsy cabs using my burgeoning Russian; escaped snipers from the 1993 civil war assault on the Russian White House; worked for the US Defense Department with brilliant but poor Russian scientists who only made $40 a month; sold the first Yellow Pages ads to Siemens in French; reunited with my Russian Jewish relatives who had been trapped behind the Iron Curtain; and I reveled with the influx of global expat adventurers, entrepreneurs, and opportunists at the Irish bars in Moscow and St. Petersburg.
In the 2000s, after going to Harvard and getting my MBA and after Russia’s fortunes turned around with the oil price, I worked in London for Renaissance Capital where I advised emerging market fund managers at Goldman Sachs and JP Morgan on their investments in Russia and Africa. Putin’s interference in the public markets seemed confined to his personal embellishment and the markets functioned relatively unscathed. We could launch successful IPOs of Russian public companies for many years (until the 2008 crash cratered the oil and Russian markets and Putin decided to invade first Georgia and then Ukraine).
Moving on to China…
After the 2008 crash, I became the macroeconomist for global mining firm Rio Tinto, and China had become the biggest customer of our commodities. China had embarked on monumental building and infrastructure spending in order to support its economy in the global crisis and to move vast quantities of Chinese people from the countryside to the urban and industrial cities. This helped prop up the global economy but came with a lot of debt.
But by the early 2010s, China’s priorities started to shift from fixed investment and very commodity-intensive growth to services and domestic consumption. But nobody in the industry wanted to admit it, as the commodity boom was just too good for Freeport, Rio Tinto, Barclay’s, Goldman and others. These analysts and executives found it too easy to dismiss any weakness in the data as one-offs.
No longer was China’s focus on foreign demand and infrastructure spending, but they wanted to stimulate their domestic markets and consumption. I again correctly and presciently warned the CEO and Treasurer that China’s voracious commodities demand was slowing — in contrast to the investment banks that continued to issue reports promoting China’s continued voracious demand for commodities.
After hiring McKinsey to perform an in-depth study, Rio Tinto finally agreed that, indeed, China’s commodity demand was slowing and proceeded mass layoffs (yeah, and yours truly got the axe) – no one likes the bearer of bad news and besides the maternity leave was too generous and backfired so that women of child-bearing age like me were economic liabilities. I returned to the US and restarted my career as a financial advisor.
China Cracks Down
Given my experience in Russia and covering emerging markets, when Chinese President Xi cracked down on Jack Ma’s ascendency by blocking Ant Financial’s IPO, it did not strike me as a broad scale attack on the Chinese stock market.
It reminded me of Putin’s edict that wealthy businessmen should not foray into politics for fear of reprisal — and Jack Ma (whom I have heard at Davos and is one of the most brilliant men I have listened to) had run afoul of this protocol. Besides, even US representatives are trying to curb the monopolies of mega tech firms and the mega-power of their CEOs.
Yet it was when Xi forced public, for-profit tutoring companies to become nonprofit that it belied more fundamental changes in China. Unlike with Jack Ma, this was less about ego and more about ideology and data protection. Later we learned the impetus for these striking challenges in China’s iron fist was not just about ideology – it was about national security.
For years, China had ignored its birth statistics and deteriorating demographics until it could not hide anymore. China’s low birth rate had become an existential threat.
Thus, the officials went after cost factors that had hampered birth rates like the high costs of educational tutoring and property prices. Targeting these things also has the side benefit of clamping down on some of the unofficial lending involved in these consumer platforms, which only adds to debt levels.
Inequality had become a renewed demon to fertility.
So I don’t think this something that will blow over. Instead the tenuous regulations may unwind and with them will go the blind eyes that both US and Chinese regulators took.
Already both US and Chinese regulators wonder why so many Chinese companies have been able to list in the US without providing de riguer accounting information.
A major reason is that the entities listed in the US often were shell companies loosely linked to the mainland companies, a structure used to meet US and Chinese regulatory requirements, but one that gave the investors little recourse.
Now, both Chinese and US regulators are cracking down on Chinese companies listing in the US. And it’s worse than most US investors realize, now that the Chinese government blocks foreigners from owning or investing in many Chinese companies, as SEC Chairman Gary Gensler warned this week.
Risk of a Bigger Unravelling
Besides high-profile investors like George Soros and Cathie Wood dumping China stocks (though there are others buying into the market), the Chinese market could meltdown further if global index creators like MSCI respond by changing their criteria in a way that de facto reduces the amount of Chinese companies in their funds.
The index fund creators seem to be driven more by opportunism than composition integrity. Therefore, I would not be surprised if MSCI somehow changes the composition of its EM and International benchmarks to reduce China holdings. This would affect trillions of dollars in EM and international funds benchmarked to the indexes — including those in your portfolio.
China currently represents more than a quarter of the $47 billion-market-capped MSCI Emerging Markets Index, which is used as the benchmark for over $1 trillion worth of active mutual funds and passive ETFs.
When I advised emerging markets funds in the 2000s, “emerging markets” was almost synonymous with BRICs.
But a few years later MSCI and other index providers changed the whole composition and methodology to favor Asian stocks. I don’t think it was a coincidence that MSCI rejiggered its EM index to be dominated by high-performing Asian countries when the commodity-driven Brazil and Russia were flailing.
In addition to the crackdown on Chinese stocks, Chinese high-yield bond prices are tumbling too, due to the government’s campaign to reduce debt in sectors such as real estate, which put many developers in a tight spot.
Besides the problems of a low birth rate, tensions with China were reaching a tipping point with Taiwan, Hong Kong, Covid, Xinjiang etc. As my Harvard International Security Professor Graham Allison called the Thucidydes Trap, China and the US seemed destined for a conflict.
Now the question is if we will just have a cold war of cyber attacks, espionage and isolationism or if a hot war is in the cards. The shortage of resources from semiconductors to rare earths and potentially water make it hard to rule out this prospect. Either way, the impact for investors is likely to be rocky as both China and the US governments intervene more in supply chains and use a range of sanctions and tools of economic warfare.
We use ETFs and mutual funds rarely as we found that we can be more strategic and get better returns for clients with lower tax efficiency by investing in individual stocks.
If you do want to invest in China, it may be best to invest in industries like EV and automotive which support the Chinese government goals of energy efficiency and high employment.
Most financial advisors are not this strategic, nor do they understand the world and what they are actually invested in. Please contact me if you want someone who understands and cares about these global risks so we can achieve better returns for our clients with lower risks. We sold out of our clients’ China holdings weeks ago to protect our clients from this China meltdown.