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Multi-Asset Strategist Adam Berger and Macro Strategist Santiago Millán discuss the recent challenges facing China’s financial markets, from COVID restrictions to regulatory change, as well as the longer-term case for a China allocation.
Adam: China’s stock market has really struggled over the past year (Figure 1). Looking ahead, what are the big questions the market needs answers to?
Santiago: I see three key questions. The first relates to the pandemic, and in particular the question of whether China will stick to its zero-COVID policy or switch to a mitigation strategy. The second question is how China will navigate the Russia/Ukraine conflict. Not long before the conflict began, China and Russia had moved closer to one another via a series of agreements. Going forward, China’s actions relating to Russia could impact its efforts to become more integrated in the world economy. And the third big question is how China will define its new policy direction. The concept of “common prosperity” comes up often, but the definition of that phrase is unclear. Specifically, does it imply a retreat from the embrace of markets that we’ve seen over the past 40 years?
Adam: There is, of course, a wide range of possible outcomes associated with each of these questions. But at this stage, what is your sense of how they might be resolved and over what time frame?
Santiago: It’s not an easy question to answer, but it appears to me that China is prepared to institutionalize zero-COVID policy. By that I mean building an entire infrastructure for testing within a 15-minute walk of almost any spot in the country, as well as establishing the human capital infrastructure required to respond when cases rise. I would note that China continues to get better at contact tracing and other measures for controlling COVID. What all of this means in terms of China’s integration in the global economy is very uncertain at this stage, since zero-COVID, by definition, requires restrictions on entering and exiting the country.
Turning to the war in Ukraine, I will lean heavily on the view of Thomas Mucha, our geopolitical analyst. He expects a frozen conflict, meaning there will be no clear resolution one way or the other. I think that leaves China in a position where it tries to be neutral, though the West may view that as implicit support for Russia. That leaves the risk of secondary sanctions on China on the table. However, I think such sanctions would largely amount to more of what we have seen between China and the West in recent years, and so I wouldn’t be especially concerned about a situation like that.
Finally, on policy direction, I think near-term events will bear watching, including the upcoming Party Congress. But to illustrate how difficult it can be to predict a moment like this, the last time there was a historical change in China’s policy direction was 40 years ago, with the “reform and opening” policy. And for the first 10 years or so, it was not entirely clear what reform and opening meant. In hindsight, of course, we know it was very positive. So I would say that for now everyone will be in a “wait and see” mode with regard to the meaning of common prosperity.
Adam: So, if you take all of these factors into account, how does it impact your investment outlook for China?
Santiago: In the short term, I do think lockdowns are easing and there are signs of a tentative but determined reopening. Meanwhile, there are indications the cycle has bottomed and stocks are cheap, which means there is upside.
So, what’s keeping me from really having conviction that China is back on track from an investment standpoint? There are a lot of questions to be answered between now and the end of the year — in particular, about the potential for further COVID outbreaks and the outcome of the Party Congress. I would note that those risks are symmetric — there is upside policy risk as well as downside policy risk. And, of course, there is a great deal of geopolitical risk that could impact China, including the midterm elections in the US. Leading up to the election, China will likely be a topic of a lot of the geopolitical rhetoric.
Adam: Let me wrap up by sharing a few of my own near- and long-term thoughts on the case for allocating to China.
Worries already priced in — As Santiago noted, there are clear near-term challenges, and they have had a significant impact on equity prices. In fact, I think it’s possible that many of the worries are already largely reflected in the market.
The long-term case still holds water — I think the long-term case for investing in China remains largely intact. It may be even stronger after what I think could be called a lost decade for equity investors. Over the 10 years ended in May 2022, Chinese equities (CSI 300 Index) were up about 4% a year. Global equities were up about twice that. So, a very compelling decade for economic growth in China was not fully reflected in market results.
Looking ahead, I think China’s economic advantage could finally become the tailwind investors expect. On top of that, we continue to view the market as being attractive for alpha generation. The risk, especially for foreign investors, is that geopolitical challenges overshadow these positives.
Western regulation bears watching — Recently, China has been the focal point for concerns about regulatory risk. But I’m increasingly worried about Western regulation. For example, taking into account Santiago’s point about the 2022 US midterm elections, could we see the US more aggressively regulate (or even limit) investment in China?
Given the multiple uncertainties, I’m concerned that it may be too early to overweight China today — though I would note that being underweight also brings risks, especially if we are close to the bottom for the Chinese market. My long-term view remains positive, and I think this is a good moment to have a checklist (or glidepath) to help guide the decision about when to reengage: What are the key indicators, whether they relate to COVID policy, Russia, regulation, or other considerations. At the same time, I would also remain vigilant in monitoring the long-term risks and size positions accordingly.