The recent humbling experience in Russia raises the question as to how we deal with country risk in our allocation decision-making.
The first thing to say is that we do not attempt to slalom between emerging market geographies according to short-term macro bets. Our preference is to identify companies with sufficient structural growth prospects and business resilience to outrun periodic currency and macroeconomic headwinds. For instance, Egypt is a country where the macro prospects right now are fairly poor. For our holdings here, we expect high earnings growth and reasonable valuations to compensate us for these country risks. Our largest Egyptian holding by weighting, is highly profitable, has a net cash balance sheet, and has compounded revenues at over 30% over the last five years.
We are mindful, however, that we haven’t always got this area of our process right, and indeed historically we allowed our bottom-up focus to prevent us from taking prudent steps to avoid obvious macroeconomic pitfalls. Egypt and Turkey in 2016, for example, represented more of one of our funds than they should have given the apparent likelihood of heavy currency devaluation back then. While we saw little reason in terms of long-term conviction in the underlying businesses to reduce our exposure, we should have recognised the point at which macroeconomic headwinds became insurmountable relative to our local holdings’ earnings growth; and that the degree of currency risk we were choosing to underwrite was becoming excessive. We are also wary that markets with tighter liquidity should be forced to clear a higher bar in terms of overall risk management, given the relative difficulty in selling if circumstances take a turn for the worse.
Of course, most macroeconomic shocks will not be so obvious in advance, nor so targeted to individual countries. However, where potential macro-related ‘punches’ can be most clearly identified, we should obviously avoid running straight into them. Our Egypt weighting more recently, therefore, has been cut by half since the start of the year, while we wait for the clouds to clear.
When we talk about country risk, the elephant in the room here is, of course, China. In contrast to any of the countries mentioned above, this is a fairly chunky weighting in two of our funds (c. 20%). A whole confluence of factors has meant foreign investors have aggressively re-priced country risk in China over the past year. These include a regulatory clampdown (the so-called ‘Common Prosperity Agenda’); stress in the all-important real estate sector; the country’s unique approach to tackling COVID; the potential de-listing of Chinese ADRs; and most recently, China’s apparent alignment with Russia, and the risk of sanctions ‘spillover’ that this may entail.
We acknowledge the fact that some western investors may simply find China’s system too ‘different’; that investing there carries risks that are too hard to underwrite; and others may simply believe that this system is mis-aligned with their values.
Taking on some of the specific concerns. First up, we suspect a large part of the market’s fear of China stems from the specific vulnerabilities facing ADRs. However, as we write this it does look as though both sides may be approaching a sensible solution here. It is particularly interesting that the Chinese side has seemingly concluded that this issue is sufficiently important to compromise over, which in itself is surely a positive signal that the government does in fact care about keeping foreign investors on-side, and does in fact want to create a stable capital market environment for private enterprise.
A second concern for investors is the widespread clampdown seen over the past year against businesses seen by the government as promoting certain forms of social harm. This is part of the broader regulatory push towards ‘Common Prosperity’ – an attempt to shift China towards higher quality, more inclusive growth, and to address long-standing problems such as weak demographics and rising inequality. These are not controversial objectives, and indeed are essential ones if China is to progress beyond its current middle-income status.
Drilling down beyond the higher-level objectives of Common Prosperity, it is hard to argue with the substance of each regulation. Indeed, Western authorities are grappling with many of the same concepts: how to prevent the growth of ‘gig economy’ platforms from fundamentally debasing labour rights; or how to manage the massive expansion of lending facilitated by fintech mediators who bear no credit risk themselves, and thus are not incentivised to monitor credit quality; or how to prevent the natural ‘flywheel’ tendencies of online marketplace businesses from morphing into monopolistic power.
Even if they may understand the motivations behind these regulations, investors have undoubtedly been unnerved by the rapid cadence of regulatory change, as if this implied a blanket hostility to business, particularly in the technology sector. But we would do well to remember that ‘China speed’ is one of the main reasons why investing in China has been such a worthwhile pursuit. For all its wealth today, the country as recently as 1980 had a GDP per capita equal to Ghana.
There have been positive developments on this front over the past month, with Chinese authorities signalling that they hope to draw a line under these regulations quite soon, acknowledging the importance of creating a stable and transparent legal environment for private enterprises and investors. Indeed, we very much see the entire thing through this lens – it is China’s way of moving away from its prior state of regulation via personal relationships to one that is more rooted in the rule of law. But we accept that the pace of this intended transition has been uncomfortably bracing for many.
We perceive a natural alignment between our own ‘purposeful growth’ focus on businesses generating value for all stakeholders, and the government’s recent drive to re-privatise previously socialised liabilities.
There may even be a silver lining to the regulatory clampdown for those businesses which have managed to escape regulatory scrutiny, in helping to encourage more sustainable practices across the corporate world and greater long-term thinking. We have been greatly encouraged by some of our holdings’ openness to engaging on ESG issues in recent years, and indeed have had numerous productive conversations consulting on climate initiatives, diversity and cyber security.
The other major risk associated with China is its relationship with Russia, and whether this could mean the West extends sanctions on to China as well. We obviously don’t write off this possibility, but believe that it is unlikely given that China is far more systemically important to the global economy than Russia, and it would therefore be orders of magnitude more difficult to exclude it from the system in the same way as Russia has been. With inflation clearly escalating as a result of the Russia sanctions regime, this will make taking similar steps against China far, far harder. But perhaps the most important consideration here is that China has real influence and leverage over Russia. If there is to be any chance of pulling this situation back from the abyss, of preventing further atrocities, of attaining peace, China will be one of the key protagonists in making that happen; or at the very least, restraining Russia to some extent. Aggressive sanctioning of China is probably not going to help us in resolving this disastrous situation. For its part, we think that China does still want to be part of the rules-based international order, and realises the importance of maintaining at least a working relationship with Western countries. There is simply no alternative if we are to deal with matters of shared interest (climate change, global health, trade etc.).
Hence it seems to us unlikely that China will be hit by these sort of spillover sanctions in a direct way. A more meaningful risk, however, is that ‘self-sanctioning’ amongst western organisations starts to reduce foreign capital flows to China. We have already seen hints of this over the past couple of years, with Western corporates choosing to diversify their supply chain dependence away from China (albeit more the result of prudent risk management as opposed to ethical concerns). Furthermore, it is possible that some Western portfolio investors may choose to put China in a separate risk or ethics ‘sleeve’ according to their opinions on each.
We don’t see our role as that of taking any morally-driven stance on different political systems (although we respect the right of other investors to take that approach). Our role in the world is that of identifying a small number of exceptional businesses that are able to create value for wider stakeholders (including ourselves), and which can do so without being affected too much by the actions of governments.
Viewed through that lens, we continue to believe that China is a market that is well worth the effort, being home to a number of these exceptional companies. We think it is best navigated by owning businesses which are aligned with the contours of government strategy but not needy of policy support, and which are not dependent on external demand. In other words, self-reliant, domestic-demand-driven businesses which contribute to ‘common prosperity’, but remain masters of their own destiny.
All that being said, our bottom-up process has so far led us to a position of being relatively underweight China compared to most emerging market funds. Nonetheless, we are very much open-minded to identifying additional opportunities here, particularly those which provide climate change solutions, given the global importance of Chinese companies to decarbonisation.
