Investing in China Q&A

The tension between China and the US is one of the key secular challenges that we face as investors, alongside the global debt overhang, sustainability, and high asset price valuations. These are the challenges that are going to define the investment environment over the coming decades, so we need to take a considered approach to their management. Here, we explore our approach to navigating the rise of China in portfolio construction.

In big picture terms, we’re moving from a world dominated by one power, to one with two power zones, with the countries in between potentially caught between the two. Professor Graham Allison famously pointed out that in 12 of the past 16 cases in which a rising power has confronted a ruling power, the result has been military conflict, a dynamic he describes as the “Thucydides Trap”. But conflict doesn’t need to be military to have ramifications for investors. Indeed, trade wars, technological competition and shifting economic influences have already had major effects on capital markets. Only 10-15 years ago, if you’d looked at a world map showing countries’ main trading partners, the US would have coloured the world, and China’s presence was limited. Today, that has almost flipped on its head. This growth is one of the main reasons that we are seeing this increase in tensions today. Since 2008, China has caught up in terms of both military and economic strength and is becoming more assertive.

Clearly, we have passed the age of Chinese integration and moved into a competition phase. But there will be both conflict and co-operation within this broader dynamic; global powers will need to collaborate to tackle climate change for example, but we are unlikely to see any lessening in the disagreements over Taiwan or the South China Sea. We’re also likely to see heated competition between the US and China to become the world’s leader in technological development: in AI, biology, genetics and clean technology. All of this leaves a complex picture of both risk and opportunity for investors.

The first thing to note is that geopolitical tensions can impact growth and trade. But unlike tensions between the US and Soviet Union for example, this is a scenario in which investors can access technological innovation on both sides of the conflict. Indeed, if you want to capture the full array of growth and innovation available globally, then it’s important to have globally diversified exposure. Global indices - and consequently most investors – are overexposed to the west, and particularly the US, but clearly there is opportunity to be had on both sides. Today it is less of a question of whether to invest in China, than a question of how to balance your allocation.

Aside from the geopolitical and macroeconomic forces behind China, lies the simple fact that it offers relatively more attractive valuations than other major economies (particularly the US). This is reflected both in equity markets and in the bond market, where you find higher real yields.

The message from both the US and China, is that they want more self-sufficiency, they want their supply chains to be domestic where possible, and they want to become more self-reliant. This might not be good for overall global growth, but it does point you away from multinationals, and towards more domestically focused companies that will benefit from onshoring and building up of national capacity. These are typically smaller market cap companies that sit on the value end of the spectrum. So in terms of stocks, the answer is to go active, go local, and to invest with specialised managers who know the nuances of their domestic markets. In China, there is more security in many ways with investing directly in the A share market than investing in ADRs (American Depositary Receipts) or VIEs (Variable Interest Entities), which are under threat of Chinese regulation.

No, in fact on the contrary, the competition to be a technological leader is also creating investment opportunities in the US. You could even argue that the US system carries greater advantages in fostering innovation that may well lead it to prevail. But valuation matters: the most innovative companies in the world won’t produce stable returns if they prove to be excessively overvalued. That’s why selectivity is key here, you need to take valuation into consideration and select the best of the US companies at the most attractive prices.

Before jumping to the conclusion that China is going to suddenly nationalise their companies, it’s important to understand why they’re taking the actions they’re taking. If you look beyond the regional differences, China is facing many of the same challenges that the US and the Western world face; the monopolistic power of big tech companies, growing social inequality and the desire for higher wages. What’s more, their government has the same aim of any other government; to perpetuate itself. In Western democratic societies that means appealing to the electorate, and in China that means pursuing stability. In lieu of the economic growth that fuelled social satisfaction and stability for so many years, China now has to find other means of keeping tensions to a minimum. That’s what’s behind the state pressure on private companies.

Population growth has also slowed down rapidly, which is why the state is trying to reduce the cost of raising children by recent action in the healthcare and education sectors. There is also pressure on broader sectors of the economy to lower prices and raise wages. On the negative side this means slower profit growth, but that risk is countered by China’s desire to encourage economic growth and foreign investment in the longer term, which increases the likelihood that these measures will come to an end at some point.

So clearly there are risks there, the question for investors is whether they are accurately priced in. Our view is that there has been an overreaction in some areas, with foreign investors pricing in too great a risk premium. Furthermore, a lot of government measures are aimed at multinationals, while domestic companies are in many cases faring very well. Regulation is certainly a threat, but the risks can be mitigated by understanding which sectors the government is likely to target. Reading the five-year plan is an essential piece of research to undertake when investing in China.

There is no questioning the fact that China’s ESG credentials are weaker than that of other advanced economies. On the environmental side, China is the number one polluter in the world, and it has the largest amount of coal powered electricity in the world. On the social side, human rights abuses are clearly an issue, and on the governance side, it is far behind its international counterparts. However, when we’re thinking about ESG, we’re not just looking at scores, we’re looking at engagement and improvement.

• Environmental

• Social

• Governance

Similarly, China scores very poorly in terms of disclosures, but disclosures in the largest companies in the CSI Index have more than doubled in the past 10 years, and new regulations are coming in to make those disclosures consistent across the economy. The data might still be poor, but more information is getting to investors, and there is increasing governmental pressure on this front.

What’s important, is that investors encourage better practice on all these fronts. For us, it is not a question of excluding, but of engaging. There are clear challenges for China to confront on the ESG side, but it is a more nuanced picture than is often portrayed, and foreign investors will play a key role in driving change.

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