CIO Office Viewpoint – 03.04.2024: How to trade your dragon
By John Woods, CIO APAC and Michael Strobaek, Global CIO
Key takeaways
- China’s policy priorities have eclipsed markets, leading to net outflows as the world’s second-largest economy is too big to ignore, but too uncertain to inspire investor confidence
- We removed strategic allocations to Chinese debt and equities in late 2023. Tactically, it is still too early to take a positive view on direct investments into Chinese stocks, bonds, or the yuan
- However, we see tactical alternatives to direct China exposures that can contribute to returns in a globally balanced portfolio
- Proxies include Europe’s luxury goods makers, and equities in South Korea and Taiwan, which are economically correlated with China. Beneficiaries of ‘friend shoring,’ including India and Mexico, may also gain from new capital and technology flows.
For decades, investors thought they had grasped how to make long-term returns on China’s equity market. They factored in seasonal economic effects on earnings, the sectoral rotation between state-owned firms and their privately-owned counterparts, as well as the impact of capital flows and the currency overlay. Then President Xi Jinping came to power and changed everything.
China’s president appears to play by different rules from developed market investors. He seems to apply policies that he believes benefit his own government and country. The importance of the financial market – even among local investors – comes a distant second to the common prosperity captured in China’s polity, economy, and society.
This realisation has been jarring. Since a peak in January 2021, the MSCI China Index has fallen by over 50%, leading to a belief among certain Western investors that China’s equities are ‘un-investable.’ This perception is even more salient as US, European, and Japanese stock markets post new records.
In 2023, for example, almost USD 69 billion left China on a net basis, according to China’s State Administration of Foreign Exchange. In 2024, China’s stocks and bonds will likely suffer a similar USD 65 billion capital outflow, according to the Institute of International Finance. Meanwhile, foreign direct investment has flowed to other markets (see chart 1).
But China is still the world’s second-largest economy; too big to ignore, but equally, too fraught with complexities and uncertainties to invest in with long-term confidence. We therefore examine alternative ways to get exposure to ‘trading the dragon,’ which can contribute to returns in a well-diversified, balanced portfolio.
Sugar rush
Although Chinese stocks may be in the grip of a bear market, there will be tactical investment opportunities from time to time. Indeed, in the two months to early April, the MSCI China Index spiked 11%, reflecting evidence of economic stabilisation, liquidity from the People’s Bank of China (PBoC), and aggressive buying by state-owned and/or influenced institutions known as the National Team. Arguably, the market was also technically oversold.
The problem is that what might look cheap today can get cheaper tomorrow, and these bear market rallies are as frequent as they are fleeting. They rarely provide an opportunity to build a credible long position before investors have to give up gains over the following weeks. There’s a reason for this. Earnings, valuations and technical factors used to be the yardsticks driving China’s markets. But in recent years, policy settings and policy makers have taken over. As investors are finding out, it’s difficult to anticipate when new policy might be announced, its contents and effects.
Beyond short-term investment opportunities, three powerful and structural features combine to prevent a meaningful rally in China’s equity markets. These are, in order of importance: a heavily indebted property sector, the balance sheet recession that subsequently flows from this as corporates are forced to pay down such debt, and more broadly, the economic excesses that result from a development model that prioritises government-led investments over (private) consumption.
It doesn’t help that investors are also assailed by insolvencies, defaults and bankruptcies coupled with fraud cases. The latter include an alleged USD 78 billion overstatement of revenues by a large property developer, one of the biggest financial frauds in history.
Proxies for China
For China investors reluctant to time short-lived rallies, there are ‘proxy’ opportunities outside of China. European luxury goods sales, for instance, have long reflected Chinese consumers’ discretionary spending, and some key firms have managed to outperform Chinese indices even during relief rallies. Countries such as South Korea, Taiwan, or ASEAN’s[1] equity markets all offer an economic correlation with China, often thanks to travel-related demand. Positive surprises out of China can then have a meaningful impact on earnings sentiment in these markets.
For those anticipating a classic, stimulus-led cyclical rebound, base metals such as copper or bulk commodity proxies like the Australian dollar can also offer some exposure to Chinese economic demand. Despite the lingering confidence crisis among China’s real estate developers, there is a constructive way of accessing this. Housing completions exceeded housing starts in 2023 for the first time in 26 years, and may be rebounding as projects continue to receive financing support from the authorities via a project recommendation mechanism known as ‘white-lists.’ The government’s support for urban investments in large cities is also anchoring China’s demand for industrial commodities. If coordinated policy easing by Beijing proves even moderately effective in stabilising homebuyer sentiment, markets could be surprised by the tight demand-supply balance for copper and bulk commodities.
For such proxy positions however, disciplined profit-taking is essential given the complex, long-term challenges in place. For example, China’s housing completions may support short-term industrial commodity demand, but that also implies that the collapse in recent years of housing sales is not properly reflected in China’s growth. That will change.
Reshoring dividend
Investors might also anticipate beneficiaries of global reshoring or ‘friend-shoring’ trends. Much depends on how global supply chains settle, as well as the US presidential election that could change expectations around trade. Still, a few countries offer well-diversified economies that may benefit from foreign capital and technology outflows amid geopolitical uncertainties.
India, Japan, Mexico, and Poland stand out in this regard. India offers a combination of attractive structural growth, including favourable demographics, market-friendly policy conducive to faster industrialisation, and a strategic position between the US-led and Chinese-led trading blocs. India is positioned to trade and invest for its own long-term economic development, unlike many industrialised Asia Pacific (APAC) peers, where the cost of realignment with the US and its allies may offset the benefits of friend-shoring. Japan, meanwhile, may benefit most within the US-led bloc as a country with an extremely competitive currency, advanced trade deals with all key US allies, and a secular shift in strategic capital expenditure. Equity markets in both countries have rallied substantially, meaning active investors should be patient for now.
Mexico and Poland are also benefitting from friend-shoring in North America and Europe, and they have the right ingredients (geographic proximity, high sensitivity to larger export market, tech diffusion) to emerge as new regional manufacturing hubs. They would then supplant some of China’s dominance in the coming years. For Mexico, however, a Trump administration after the US election could exacerbate the risk of border disruptions.
In Asia, ASEAN countries may benefit economically from the rules of origin arbitrage for China’s manufacturing exports (especially Malaysia, the region’s hub for such activities), but their high correlation to China make them more appropriate as a proxy trade for China.
We removed Chinese debt and equities from our new strategic asset allocation late in 2023 to reflect our assessment of the country’s long-term challenges. China remains one constituent among many in our emerging market equity and hard currency debt allocations. At the tactical level, we believe it is still too early to take a positive view on direct investments into Chinese assets, including stocks, bonds, or the yuan. However, proxy portfolio exposures are worth considering for the broad benefits of both diversification and balance that they can offer, without many of the uncertainties surrounding China’s volatile policy environment (see chart 2).
[1] The Association of Southeast Asian Nations (ASEAN) comprises Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei, Vietnam, Laos, Myanmar and Cambodia.