The China Hurdle
The world is starting to digest the potential for emerging market growth the be reflected in the performance of emerging market assets. See ‘Waiting for Spring’ blog as well as bottom-up pieces on India, the Philippines and Vietnam.
As bottom-up investors in emerging markets who have been dutifully tracking decent earnings growth of stocks whilst the share prices tumbled, we wouldn’t be human if we didn’t have to manage our own anxiety. The question we have been asking ourselves is could it be different this time? Could the great rotation to emerging markets fail to materialise?
Admittedly, this is certainly possible, the main reason being that China is clearly a very different country with a different risk profile to what was the case at the start of the last EM bull market (1999), and is dramatically more important in terms of its weighting in the EM index (31% today versus a mid-single digit percentage back then). As one of our investors put it recently, Russia’s invasion of Ukraine prompted a real “back to basics” approach when it comes to how to price geopolitical risk, with conversations about war, expropriation, capital controls, and sanctions now coming up frequently, possibly for the first time ever for many younger allocators.
Our conversations with allocators during 2022 have revealed a range of positions on China. Many are cautious but still long-term optimistic given the scale and depth of the market, as well as the innovative, dynamic nature of Chinese enterprises. Others are taking a ‘wait and see’ approach before even considering any further allocation. A small minority are terrified by the prospect of an invasion of Taiwan, and hence have de-risked. The view that all of these stakeholders share is that China is the main hurdle to flows to the broader EM ‘asset class’ – it is the most common issue that comes up in investment committee meetings as the reason not to invest in emerging markets. We think that as and when China-related fears begin to abate, this will remove a major impediment to flows into emerging markets.
We set out our views on China in detail here in this recent blog post, the short point being that we don’t think a planned invasion of Taiwan is likely (an accidental confrontation is a more plausible risk, however), and we don’t think a neo-Maoist assault on private enterprise has happened or is likely to happen.
Since we wrote this China blog post, events have moved on rapidly – there has been a massive stimulus directed towards the property sector, and what seems to be a dramatic unwinding of the longstanding ‘zero covid’ policy. Whilst the latter may seem abrupt and possibly reckless to some, it does at least show that the system has greater capacity for flexibility and course correction than many had assumed. It may indicate that Beijing tacitly recognises that sacrifices may need to be made with regard to the broadly defined ‘security’ in order to prioritise the economy, the strength of which is the main currency of the Chinese Communist Party legitimacy. This interpretation was lent further credence by the conclusions of the Central Economic Work Conference (held in mid-December) which placed marked emphasis on reviving consumption and private entrepreneurship, whilst hinting at a peak in regulatory tightening. It even cited the explicit intention to “support platform companies to play key roles in leading development”. There will inevitably be severe disruption to both end consumer demand and logistics over the next quarter as China deals with the spread of covid. However, after three years of covid-related policies, Chinese households are flush with cash – almost USD5tn dollars in savings is sitting in their accounts (a c.40% increase versus early 2020), much of which we think can be directed towards our sort of consumption-driven holdings.
Meanwhile, on the US side, auditors were able to access the books of Chinese companies listed in New York, thus removing much of the prior risk of de-listing from New York that hung over the latter.
Chinese equities have surged in response to the above developments. We have no idea how sustainable this rally will be, or indeed whether it really represents a sea change in foreign investors’ attitudes to China. But it is worth drawing a few lessons from history. The peak to trough of the current drawdown in China has been a 63% correction, whilst (following the recent recovery) we are now about 50% below the peak.
The last time something of roughly this magnitude happened was in 2015 and early 2016, where fears over credit quality in China led to a 43% drawdown over a much shorter space of time. We recall with some embarrassment that at the time we cut back the China exposure, instead choosing to hold cash at levels unprecedented for us. This seemed prudent at the time given how relentlessly negative sentiment towards China was back then. As we all know, this proved to be a big mistake, with sentiment flipping very quickly in February 2016 from despair to optimism in China’s burgeoning digital revolution, prompting an epic bull run for China that delivered 22% annualised trough-to-peak returnsover the following six years.
The simple observation from the above is that the sentiment of the market ‘herd’ can swing very rapidly. Memories are short, and new narratives quickly replace prior ones. And we think that if and when new narratives establish themselves for China, this could unlock a wider rally for emerging markets.
 MSCI Emerging Market Index
 Source: https://www.ft.com/content/e592033b-9e34-4e3d-ae53-17fa34c16009
 Source: MSCI China Index for figures
 Source: MSCI China Index for figures
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