China’s appeal as an investment destination dims but does not disappear

Russia’s invasion of Ukraine has been a wake-up call for investors in China, reinforcing their convictions that authoritarian governments can be a big risk for investments.

Unpredictable regulatory crackdowns, anti-democratic tactics, financial coercion, the physical intimidation of citizens, as well as growing tensions between the US and China and the potential threat of Beijing’s ordering an invasion of Taiwan, have prompted asset allocators to review their investments in the world’s second-largest economy.

“We have watched China’s human rights track record deteriorate considerably, as Xi Jinping has solidified his power in the past decade, and we have become increasingly concerned about our exposure to such abuses,” says Sonia Kowal, president of Zevin Asset Management. During the summer, the US impact investment firm divested from its direct Chinese and Hong Kong holdings, hoping to be able invest in Chinese companies again when the country finds itself on a “more sustainable path” in the future.­

“From a social perspective, the crushing of Hong Kong democracy activists in 2018 continued horrendous abuses of the Uyghur population, and dystopian social engineering leave us deeply uneasy about investing in China,” says Ms Kowal.

From an investment perspective, the political crackdown on companies and industries deemed not submissive enough to Chinese government goals does not fit with the firm’s low-risk investment philosophy, she adds, explaining that China’s “repressive regime” makes it hard to engage policy-makers and companies to advance issues such as human rights.

Too big to ignore

But if boutique asset managers can afford to take such decisions – Zevin’s disinvestments amounted to $11m, or less than 2 per cent of its AuM – wealth managers believe the Chinese economy is too large to simply dismiss it when managing private client portfolios.

“When we look at the next years, if not decades, there is no way we can exclude China from investment decisions,” says Pictet’s head of macroeconomic research Frederik Ducrozet.

China’s equity market is just 10 per cent of the US stockmarket, but it may rapidly double or triple in size, as the country transitions from an export economy to a consumption-based one.

The Chinese Communist Party, which is hosting its 20th Congress in mid-October and is expected to confirm president Xi Jinping for an unprecedented third term in office, aims to double the size of China’s economy by 2035. This means the country will have to maintain growth rates of around 4 per cent per year for the decade ahead.

Short-term headwinds, such as draconian Covid restrictions and property sector deleveraging, make it hard to invest in China, but the economic outlook is gradually improving, says Mr Ducrozet. “We've been underweight China for two years, and are starting to increase risk recently, mostly because we think that it cannot get worse at this point, it can only get better.”

Continuous lockdowns are causing an “ever postponed recovery”, which will ultimately lead to “a strong market rebound given huge pent-up demand”, supported by China’s fiscal and monetary stimulus.

Swiss bank Lombard Odier has a “constructive view” on Chinese equities, believing that investing in China is very different from investing in Russia.

“Russia today is a political, legal, and economical outcast,” says co-head of Lombard Odier’s private client business Frédéric Rochat.

“Nobody invests in Russia, whether for ethical or not ethical reasons. But China is the biggest trading partner of the European Union and the US. Not investing in China may be an ethical decision, but exclusion cannot be based on risk management reasons today,” says Mr Rochat. While it remains to be seen whether China will remain integrated in the international trading system in the decades ahead, Lombard Odier sees no risk of war in the short term.

The bank believes China will be able to avoid a ‘hard landing,’ as it has done in past crises through policy support.

“China went through the worst first half of the year in over a decade, in terms of GDP activity, which means that purely from a political level, the second half of the year must be better,” says Sami Chaar, chief economist at Lombard Odier.

The economy expanded by just 0.4 per cent in the second quarter, a dramatic decline from 4.8 per cent growth seen during the first quarter. It is “unacceptable” for Chinese authorities to continue to have such low growth momentum, he says.

Indeed China is the only country in the world loosening its policy, while other nations are tightening their fiscal and monetary policy.

Another encouraging sign for the economy is that while lockdowns continue to hit Chinese cities, unlike in the first semester, production is still running, and activity in the country’s ports and trade are gradually normalising.

Attractive valuations

Within a neutral allocation to equities, Lombard Odier has held an overweight position in Chinese equities, relative to other emerging markets, since May 2022, partly due to cheap valuations.

“Our portfolios remain positioned to benefit from China’s reopening economy” says Lombard Odier’s CIO Stéphane Monier. “Chinese stocks continue to look attractively priced and the correlation with other global equity markets remains low. We see growth accelerating into next year, thanks to additional fiscal support, and gradually easing health restrictions,” he adds.

After the CCP congress, authorities may shift economic focus to growth, loosen Covid policies, further stabilise the property market, and support domestic industries and demand, believes Mr Monier. The economy may expand 3.3 per cent in 2022, and 5.5 per cent in 2023, depending on the pace of reopening and further policy support.

China today represents at least 16 per cent of the world's economy and a bigger share of trade. “We think it's very important that our clients have exposure to this big part of the world economy.”

While the underlying fight for supremacy between China and the US need to be monitored closely, it must be remembered that the US economy itself cannot operate without the Chinese economy. For instance, 75 per cent of the components of medicines used in the US come from China. The tension between US and China is “value destructive” for both countries and it is unlikely to develop rapidly over the next six to 12 months, says Mr Monier.

No catalysts

UBS has a neutral view on Chinese stocks in client Asian portfolios, although “the entire Asian portfolio depends on China not blowing up”, says UBS’s global CIO Mark Haefele.

China can probably “do enough” in terms of policy support to prevent issues in the real estate from becoming a systemic contagion, but “they probably can't and won't do enough to accelerate the growth levels in the economy”, he believes.

While today there are “no catalysts” to invest in Chinese stocks, given the gloomy growth picture, he expects “some mild acceleration” into the back half of the year.

China does not necessarily want to have a conflict with the US, and certainly not in the short term, believes Mr Haefele. However, US policy seems to be very different from the 1970s, when the US opening of relations with China led to the withdrawal of US troops from Taiwan, with the idea that reunification to China would happen sooner.

The situation is now exacerbated by the strong reliance on Taiwan’s semiconductor sector. The country is responsible for 63 per cent of global semiconductor market share. As the primary semiconductor supplier to the US and China, Taiwan’s semiconductor industry plays a vital role on the global scene from a geopolitical perspective.

China's confidence in being able to successfully take over Taiwan will only grow in time, predicts Mr Haefele.

Biggest elephant

Short-term headwinds are leading economists to revise down their GDP growth forecasts for China. The World Bank predicts the country’s economy will grow 2.8 per cent this year and its economic output will lag the rest of Asia for the first time since 1990. In April, the bank had predicted growth of between 4 and 5 per cent.

Disruption from new Covid-19 lockdowns, a jittery property sector and weaker global demand are concerning investors too. Around $300bn could exit the country this year, more than double last year’s outflow of $129bn, according to forecasts by the Washington-based Institute of International Finance.

While today the world faces many challenges, China is still the biggest uncertainty, states Pictet’s Mr Ducrozet, who is more concerned about China’s structural issues than its  

Zero-Covid policy.

Demographics have deteriorated during the pandemic, which may lower China’s growth potential and increase inflation. Moreover, while China will always try and find a common ground with the US and Europe and avoid escalation, war remains “a threat”, he says.

“China is the big elephant in the room, because of its huge potential. It is still the most important growth engine for the world economy.”