China May Be ‘Uninvestable’ After All

China border fence. Chinese flag behind a steel wire mesh

TheaDesign/iStock via Getty Images

Earlier in March of this year, JPMorgan Chase shocked investors and attracted controversy in the financial media for labelling Chinese internet companies as “uninvestable.”

We at Stratos Capital Partners not only agree with this assessment of Chinese internet companies, but we also view Chinese equities more broadly as becoming an ‘uninvestable’ asset class. Investors with exposure to Chinese equities should consider cutting losses as China’s economic rebound becomes ever more elusive.

Despite what we view as good intentions by its research team to warn investors of the dangers of investing in Chinese internet companies such as Alibaba (BABA), Tencent (OTCPK:TCEHY), and Meituan (OTCPK:MPNGF), JPMorgan eventually succumbed to mounting pressure from prospective clients, nationalistic Chinese netizens, and quite possibly entities linked to Beijing. JPMorgan upgraded those companies two months later claiming that the original call was published in error.

At the time of writing, Seeking Alpha’s Quant Rating has a ‘Hold’ rating for both Alibaba and Tencent, and a ‘Strong Sell’ for the broader KraneShares CSI China Internet ETF (KWEB).

Valid Reasons For Being ‘Uninvestable’

This is not the first time analysts have issued dire warnings against investing in Chinese stocks. From our standpoint as advocates of long-term investing, we too share the view that what qualifies as a high-quality investment, necessarily requires some level of visibility into future cash flows or prospects of the asset in question. When it comes to investing in China, though, the future is wildly unpredictable given the lack of transparency, weak accounting standards, and poor regulatory oversight. Worse, the fate of the Chinese economy is almost entirely dependent on the political aspirations of a single man, Chinese President Xi Jinping.

And Xi Jinping’s actions of late have been nothing short of disturbing for investors. Even former Morgan Stanley Chief Economist and long-time optimist of China, Stephen Roach, has recently issued warnings that China’s actions are signaling the early stages of a cold war.

Political Risks Overshadow Economic Potential

The political risks associated with doing business in China have relentlessly haunted the minds of business leaders over the years. In fact, most observers would agree that the uncertainties of doing business in China, are for the most part political in essence rather than economic.

Investing and doing business in highly authoritarian regimes is a double-edged sword. On one hand, decisive leadership means economic policies can be proposed and implemented quickly without having to accommodate conflicting interests (workers vs firms, savers vs lenders, welfare vs taxes, fossil fuels vs environment). On the other hand, authoritarian states often prioritise political interests over good economics. This means that economic policies may initially welcome foreign investors during the boom years, but quickly switch towards preserving political power and control during a crisis.

For long-term investors, we believe that the risk-to-reward for investing in Chinese stocks is no longer as attractive as before. As we begin to see more evidence that Xi Jinping will prioritise political interests over economic development, investors will increasingly be caught off-guard by sudden policy changes that could undermine their investments. As the chart below demonstrates, investing in China hasn’t been worth the risk over the years.

Chart showing wild swings in China equity market over the years

Bloomberg

COVID Pandemic Unveils Beijing’s Priorities

The pandemic has demonstrated how China has become more unpredictable for investors. Chinese authorities initially responded to news of the virus outbreak by downplaying the seriousness of the situation and limiting the flow of information. However, when the containment strategy failed, draconian orders were issued to lock down cities and deploy manpower (military & public health) to enforce harsh quarantine measures and maintain order.

When several countries began to explore possibilities of managing an endemic Covid by limiting the effects of the virus with vaccines, Beijing doubled down on its zero-Covid strategy, insisting that the safety of its citizens is a top priority while pointing to the high COVID death rates in the U.S as proof of the democratic world’s dysfunction.

Fast forward to the present environment, nations with high vaccination rates are reopening their economies and businesses are on the path to recovery. In hindsight, China’s zero Covid strategy makes little sense especially given that the modern global economy has become so deeply interconnected by trade and air travel. But having raised the stakes of pursuing a zero-COVID strategy and having already suffered heavy economic losses, there was no turning back for Xi Jinping given the risk of losing political support within his party. By now, Xi Jinping’s priorities seem clear to me: Politics must come first, and the economy can wait.

Russia’s Invasion Of Ukraine Has Undermined Beijing’s Clout In The Region

Russia’s invasion of Ukraine couldn’t come at a worse time for Chinese geopolitics. The invasion has placed Beijing in a difficult position of having to take a neutral stance on the war amid mounting pressure by the international community to condemn Russia, while also having to show support for its long-time ally.

This places China at risk of possible economic sanctions by western nations should the war escalate. We believe that geopolitical risks have yet to be adequately priced into Chinese equities, and investors should not rule out the possibility of deeper losses in the event of sanctions.

The Russia-Ukraine war has also provided the much-needed context for the protection of Taiwan from a similar invasion from China. Speaker of the U.S House of Representatives Nancy Pelosi’s recent visit to several nations in the region, in particular Taiwan, has been widely viewed as a highly strategic and deliberate move to expand U.S’s political clout in Asia. Not only does Pelosi’s visit symbolize Washington’s support for Taiwan, but it has also forced Beijing’s hand to retaliate by conducting military exercises surrounding the waters of Taiwan.

Leaders of authoritarian regimes often have to avoid looking weak in the face of provocations to their political ideologies at all costs, as a weak leader may be deemed unfit to hold absolute power. However, Beijing’s retaliation also means doubling down on its claim of sovereignty over Taiwan.

Beijing’s unyielding stance on other geopolitical issues and repeated display of military force in retaliation to challenges to its territorial claims in the South China Sea risks further isolating itself from other democratic nations as well as its regional neighbours. Unfortunately, Beijing’s roots as an authoritarian regime mean that any provocation from the west will leave it with little choice but to retaliate.

China’s Economic Links To The World Hinges On Geopolitical Stability

China’s market-oriented reforms and consequent rapid economic boom over the past two decades were only possible under the fragile conditions of a stable geopolitical environment and consistent economic policymaking. The importance of these conditions, however, has been largely underappreciated by the financial media.

Chart showing China Economic progress following accession to the World Trade Organization

World Bank, Bloomberg

China’s accession to the World Trade Organization (WTO) in 2001 was predicated on Beijing agreeing to undertake commitments to open up its economy and liberalize its financial markets to better integrate with the rest of the world. These commitments were meant to create a more predictable environment for trade and foreign investment where member countries would observe a rules-based approach to fair trade. However, WTO rules were not originally designed to accommodate China’s authoritarian political structure. Deeply entrenched elements of an authoritarian regime mean that many state-owned enterprises as well as private companies linked to party members are essentially taking orders from Beijing.

Chart showing China's trade with the world

WTO, World Bank, OECD

Democratic nations have hoped that by deepening economic linkages with China and allowing the Chinese economy to modernize and integrate with the world, geopolitical stability can be achieved just like how the European Union and Eurozone have done for its members. From Beijing’s standpoint, the prospect of economic growth and progress for its people would strengthen the Chinese Communist Party’s legitimacy and help entrench its power.

Xi Jinping would later reassure the people of fair economic progress through his campaign for “common prosperity” and by stamping out corruption to further consolidate his power. China was able to achieve all this partly due to its undisturbed economic progress and modernization, which diverted the country’s focus away from political ideology and onto its economic priorities. The western world also tolerated China’s rise as an economic superpower and disagreements on geopolitical issues were temporarily cast aside in the race for economic leadership. Business leaders too saw the potential for lucrative returns in China and were happy to forget China’s communist roots.

Poor Visibility Of Future Prospects Make A Bad Investment

The unpredictability of Xi Jinping’s motivations and the general incompatibility of China’s political ideology with its economic aspirations are a minefield for long-term investors.

Financial analysts struggle pointlessly with their valuation models to try and estimate what is fair value for Chinese companies. At the back of their minds, they are probably wondering if the financial statements they rely upon can even be trusted, given the spate of accounting scandals in China in recent years. Without a reasonable level of visibility into the future earnings and prospects of Chinese companies, investing in China is as good as trying your luck at the casino.

Even a purely qualitative assessment of China’s prospects seems bleak. China is currently experiencing a property market crash that could drag on economic growth for years, while there seems no end to lockdowns with a ‘Zero Covid’ strategy. For now, it appears that Xi Jinping is more interested in consolidating power, even at the expense of China’s economy.

In Conclusion…

We are of the view that the potential returns for investing in China (especially given the poor visibility of returns), simply do not justify the risks associated with investing in Chinese stocks. Investors should cut losses and slash portfolio allocation to Chinese stocks given our view that the Chinese economy is likely to linger in a crisis mode for an extended period of time.

In fact, it is almost pointless to discuss economic data and financial metrics, when China’s entire economy can shift on Xi Jinping’s orders. We certainly don’t think it is too far-fetched to say that China may be uninvestable after all.

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