Goldman Sachs first uttered the “U” word in July. In a note, strategists Kinger Lau and Timothy Moe said, “‘Uninvestable’ has featured in many of our recent conversations with clients regarding investing in Chinese stocks.”
The idea that investors should avoid the Chinese market would have been unfathomable even a few months ago. The world’s second-biggest financial market after the U.S.—one the IMF expects to grow faster than almost any other major economy this year—looked like a surefire opportunity for investors up until Beijing started cracking down on Big Tech. But the prospect of China now being a no-go zone reflects just how much the regulatory campaign has spooked investors.
The government has hamstrung some of its largest homegrown tech stars, restricting or even forbidding them from operating their most promising business lines. Authorities suspended new sign-ups for Didi Global after the ride-hailing giant went public in the U.S. and is now reportedly looking to take the firm under state control. (Didi denies the report.) The government ordered Didi, shopping platform Meituan, and e-commerce giant Alibaba to rectify past misconduct that interfered with fair competition and hurt drivers and passengers. It banned its booming ed-tech industry from making profits and kneecapped video game makers like Tencent by restricting children’s screen time. It’s all in the name of limiting what the government sees as the companies’ monopolistic power—a perceived threat to Communist Party rule—and eliminating social inequality that can lead to public discontent.
“China envisages a heavier regulatory hand and views tech as a political threat,” said Matt Gertken, a strategist at BCA Research who focuses on geopolitical and macro risks. “Regulatory pressure can materialize out of nowhere.”
The market has withered in response. Through Wednesday’s close, the tech-dominated MSCI China Index has fallen 24.9% in the past six months from its February peak, compared to a rise of 9.3% for the MSCI All-Country World Index during the same period.
Investors have stampeded out of offshore-listed stocks at a particularly rapid pace, with the Nasdaq Golden Dragon China Index, a gauge tracking shares listed on U.S. exchanges, losing as much as half its value since February. Chinese tech companies including fitness app Keep, podcast operator Ximalaya, and LinkDoc Technology have all shelved their planned New York listings.
It’s easy to see why Goldman’s clients were so worried.
But as the crackdown progresses, the Communist Party is dropping more clues about its priorities. Beijing seems to value small businesses over corporate behemoths and favors new technologies like electric vehicles, clean energy, and biotech over the “platform” companies that earned President Xi Jinping’s ire. It wants more safeguards for workers, consumers, and the country’s youth.
Nearly a year after Beijing launched its attack on Big Tech in earnest with the scuttling of Ant Group’s IPO, the question facing investors is whether to buy into the “uninvestable” mindset—forgoing opportunities from the vast amount of research and development spending taking place in one of the world’s fastest-growing major economies—or learn to follow Beijing’s lead and stack their portfolios with companies that are on the party’s good side.
Investors in Chinese equities “may feel like they are standing in front of a train wreck,” wrote John Woods, Credit Suisse’s chief investment officer for Asia, last week. “But it does not have to be like this.”
“Last in the queue”
Before the crackdown, global investors saw Chinese tech as a way to tap into the country’s rising incomes, which first manifested as soaring demand for consumer products—from running shoes to rice cookers—and later as mass adoption of mobile payments channels and social media platforms. But that strategy assumed that Beijing would leave tech giants alone to thrive and rival the West, Gertken said. The past few months have disproved that theory, leaving investors without an obvious playbook.
Some say that as a long-term bet, China is only for the brave.
“The Chinese Communist Party is master of all it surveys, and if the ready conclusion from the past few weeks is that socialist ideology has become a much more significant market factor, how could equity investors value that?” said Diana Choyleva, chief economist at Enodo Economics.
China is entering a new phase of development, in which growth will give way to a redistribution of wealth and income, she said. “In such an environment, the owners of capital—especially if they are foreign—will be last in the queue to claim their rewards.”
Some major investors say that until the dust settles, it’s too soon to be betting on Chinese tech. SoftBank’s Masayoshi Son warned in an investor presentation last month that he will “wait and see” how new regulations will impact the stock market before he invests more of the company’s $239 billion portfolio in the country. Since the start of the current fiscal year, China has accounted for 11% of the Vision Fund’s new investments; it represented one-third in the past. The fund has favored other Asian countries like South Korea, Singapore, and Indonesia and regions like Latin America and Europe instead.
Paul Marshall, cofounder of the $59 billion systematic hedge fund Marshall Wace, echoed that view. In a letter to clients, he answered the question that Goldman clients had raised a month earlier, stating that China’s regulatory crackdown indeed has made U.S.-listed stocks of Chinese companies uninvestable, according to Bloomberg.
For his part, U.S. Securities and Exchange Commission Chairman Gary Gensler has repeatedly warned against investing in Cayman-domiciled offshore shell companies—funding channels long preferred by founders of Chinese technology companies—and has demanded the management of these companies make it clear to investors that regulators in Beijing could abruptly change the rules and slash the value of their holdings.
Gensler’s stance aligns with an argument investor and philanthropist George Soros made in the Financial Times that indexes compiled by the likes of MSCI Inc. are so full of Chinese shares that many investors do not recognize they are ultimately beholden to Xi’s whims.
But others say that ignoring China is neither advisable nor desirable.
A “selective” investment strategy
“Anyone who’s interested in the future should be interested in China,” said Carlos von Hardenberg, an emerging-markets veteran and a founding partner of Mobius Capital Partners LLP. “Whoever ignores China will make a gigantic mistake.”
What’s more, avoiding China is out of the question for those benchmarked against global indexes, a reflection of hard-fought battles by Beijing to lure global investors during the past decade that now make divesting from the country more painful for fund managers.
Some China bulls are already returning to the stocks they only recently abandoned. After dumping shares earlier in the summer, ARK Investment Management founder Cathie Wood has started accumulating tech stocks including JD.com, Tencent Holdings, and Pinduoduo.
Hedge fund billionaire Ray Dalio, a longtime advocate of investing in China, urged investors to not “miss out” on China by assuming that Beijing’s actions against its tech firms represent a reversal of the government’s 40-year effort to develop a market economy “with entrepreneurs and capitalists becoming rich.”
“But don’t misinterpret these wiggles as changes in trends, and don’t expect this Chinese state-run capitalism to be exactly like Western capitalism,” he wrote on LinkedIn.
Wei Li, chief investment strategist at the BlackRock Investment Institute, told the Financial Times in an interview last month that the research arm of the world’s biggest asset manager recommends an allocation to China twice or triple the size of its weighting in the MSCI All Country World Index.
Even Goldman’s analysts did not share the dire outlook of some of the bank’s clients. “We would be hard-pressed to extrapolate the rather extreme regulations such as nonprofit orientation and capital raising restrictions to the whole equity universe,” Lau and Moe said in their report.
Louis-Vincent Gave, founder and chief executive of Gavekal, said, “The odds of another public beheading such as we saw with the education stocks [are] probably lower than traumatized investors currently price in.” Having “made their point,” Chinese authorities are now trying to avoid broader market contagion, he said.
Even if the worst of the crackdown is past, some professional fund managers are trying to identify industries and companies that are less likely to be subject to new regulation.
“China’s recent policy orientation toward a more just and equal society should intuitively reduce corporate returns on assets and equities in many of the larger private companies, especially in the consumer technology space,” said Mark Matthews, head of research for Asia at Bank Julius Baer. But, he said, there are some sectors in China that are “in accord with the government’s objectives” that remain globally competitive, citing mass consumption, health care, and green energy.
Stocks in these sectors tend to be listed outside the U.S., either offshore in Hong Kong or in the domestic Shanghai or Shenzhen markets. Buying shares there nudges investors toward another of Beijing’s long-term objectives of fostering greater international use of its currency; almost all listings onshore are priced in Chinese yuan.
“We do think China is investable, but you have to be selective,” said Jack Siu, chief investment officer for Greater China at Credit Suisse.
Owning domestically listed shares of state-owned enterprises in sectors in Beijing’s good books is a strategy that has done well in this environment. Witness the Shanghai Composite this week at its highest in six months.
Siu said investors should buy stocks in companies that are “aligned with the long-term development plan of the country,” such as the supply chains of solar and wind power and electric vehicles, and avoid those that are not. For the next three to six months, however, the Swiss bank prefers European equities over Chinese, he said.
Headaches for Chinese policymakers—social inequality, a falling birth rate, and national security challenges, particularly around data—may make for stable long-term trends, portfolio managers for Asian and Greater China equities at BNP Paribas Asset Management wrote. The health care industry will benefit from China’s demographic trends, said Mobius Capital Partners’ von Hardenberg, while greater redistribution of wealth should boost consumer staples, according to BCA’s Gertken.
Anticipating the Chinese government’s next move remains a challenge for global fund managers, but statements by the Communist Party’s top leadership committee in early August signaled that investors should expect regulation that promotes competition between smaller tech firms and the sector’s giants, protects workers against exploitation, and limits tech’s harm to teenagers and young adults.
“The recent policy changes may mark the beginning rather than the end of a long-term transition,” said Chaoping Zhu, global market strategist at J.P. Morgan Asset Management. “After claiming victory in having eliminated absolute poverty in February, top policymakers are devoting greater efforts to achieving more balanced and sustainable development.”
Credit Suisse said a basket of “regulation-friendly stocks”—in other words, those in sectors that Beijing favors, or state-owned enterprises—are up 22% in the year through the end of August. That compares to a 23% decline in out-of-favor companies, typically those owned by entrepreneurs or listed offshore in Hong Kong or the U.S.
Hunting for the next success story
But even if investors can find safe havens in China, they may not replicate the previous returns of Big Tech.
The Chinese tech sector staged massive growth year after year, creating behemoths with liquid stocks and leaders whom investors mostly trusted with their money. Even accounting for the selloff, Alibaba Group Holding’s stock price has almost doubled since its 2014 listing, while Tencent Holdings’ quadrupled during the same period.
Some mega-cap companies in industries more closely aligned with government objectives have declined since then; state-owned bank ICBC, for instance, has lost 13.6% of its value.
But other companies in “good” sectors have thrived. Since the time of Alibaba’s IPO, the share price of LONGi Green Energy Technology, a world leader in silicon wafers, has increased 30-fold.
The next generation of Chinese success stories may well be smaller, less flashy, and harder to find than the current crop of tech behemoths.
“There are companies which are worth $200 million today which will be giants tomorrow,” said Mobius Capital’s von Hardenberg. But you have to search “very, very hard.”
“In the old days, you had to just buy any given bank or developer of real estate, and you would make a killing,” he said. “Those days are over.”
Subscribe to Eastworld for insight on what’s dominating business in Asia, delivered free to your inbox.
