Friday, July 30th, 2021

The China Question

Most investors are aware that the US and Chinese governments no longer like each other as much as they did, but they may be surprised by just how bad the situation has become. Our data suggest that this is the greatest loss of confidence in China since the turn of the century. The global equity model currently recommends an underweight of -91% on China in a World ex US portfolio – and there may be further downside as a result of this week’s price action.

China has been in extreme underweight territory (worse than -75% underweight) for 12 weeks, worse than the previous record of seven weeks in 2004, and there is clearly more to come. This is more than a temporary misunderstanding between trading partners; this is more like US investors en masse withdrawing their trust from the investment proposition offered by China.

It is impossible to forecast how this situation will develop, partly because it intimately connected with the geo-political rivalry between these two superpowers. But there is one issue which China bulls frequently gloss over. President Xi is likely to be in power for at least the next seven years. He will be the first person since Chairman Mao to serve more than two terms as China’s paramount leader and he may go on for more than three, like President Putin in Russia.

The thing about a change of leadership is that it offers international investors a chance to re-evaluate a country and re-invest where appropriate. But they won’t have this opportunity in China for several years and they don’t like losing this option. When it became apparent, in 2011, that Putin was going to amend the Russian constitution to allow himself a third term, our model sent Russia to an underweight and kept it there for the next four years, almost continuously.

None of the events which have spooked investors, from the Ant IPO to Didi Chuxing and the abolition of private for-profit tuition, could have happened without the approval of President Xi and they are likely to be repeated until he goes. We cannot know how US investors will react to this situation, but we can observe what they have done in the past when confronted by similar events.

First, they increase their exposure to the US, as a safety-first exercise. Our model currently has a recommended overweight of 73% on US Equities, and we saw a similar reaction in 2011 and 2012, when President Putin made the same move. The US overweight was not caused by Russia in 2011 and is not caused by China now, but there is nothing like a bit of geo-political uncertainty for sending US investors back to the safety of their own market.

The second thing they do is to disinvest from other countries in the region. Poland, Hungary and Czechia all fell deep into underweight territory from late 2011 to the middle of 2012. At the moment, all of south-east Asia, Malaysia, Thailand, Indonesia and the Philippines is close to maximum underweight and their own all-time lows. There is clearly a Covid dynamic, but China’s aggressive attitude in the South China Sea adds a dimension of political risk as well.

The third issue investors face is what to do with the rest of their allocation to EM Equities. Here the parallel with Russia is not particularly useful because China is an order of magnitude larger than Russia in the EM index. China and south-east Asia account for some 45% of total EM capitalisation, depending on which index series you use. It is therefore very difficult not to be overweight everything else. In order of preference, our top picks in the current situation are Czechia, India, Russia and Mexico. The EM countries which have seen the biggest improvement since China fell into extreme underweight territory are Poland, Russia and India.

When this particular scare is over, US investors will have to confront the final issue. Do they feel comfortable with the fact that the US is now over 60% of global market capitalisation, the peak since global indices were compiled? This compares with 57% just before the onset of the pandemic and 46% ten years ago. If the answer is no, and if China is still out of favour, then there are only two places they can go to – Japan or Europe.

Both options would entail a shift away from growth towards value and both have similar average recommended weight over the last 10 years (+4% for Japan vs -3% for Europe), but the big issue is timing. Japan’s recommended weight is much more volatile. The standard deviation of the levels is 40% vs 25% for Europe. Japan is also a big underweight at the moment, compared with Europe, which is approaching a 10-year high. The same metric that is telling us to avoid China is also telling us to avoid Japan at the moment.

The bottom line is that China’s problem could be Europe’s opportunity. There are many other reasons for investing in Europe, but disillusionment with the pro-China consensus of the last decade may become an important factor.

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