Jeff DeMaso: You can’t go for long these days without hearing more negative news come out of China. It started with pressure on big tech, but the government has started to crack down on all parts of the economy, from real estate to education. The Chinese, and in some circumstances the global markets, have been selling off with each new policy change. So why is the Chinese government seemingly hurting their economy and stock market? And what should investors do about it?
Hello, I’m Jeff DeMaso, director of research at Adviser Investments. And today, I’m joined by our CIO, Jim Lowell, and investment team Research Analyst, Liz Laprade. Liz and Jim, welcome to the pod.
Jim Lowell: Hey, Jeff.
Liz Laprade: Thanks for having us, Jeff.
Jeff DeMaso: All right, let’s dive in. And Liz, I’m actually going to kick it off to you first. Can you give us a high-level summary of what’s going on in China?
Liz Laprade: Sure. So this year, we’ve really seen a tirade of new regulation and policies aimed at really all sectors of the economy coming out of China. Honestly, it feels like every week there is something new. The regulation crackdowns really started gaining global attention earlier this year. First I’ll give a quick high-level timeline, and then I’m going to go into why the government is doing this.
I think the first thing that happened that really shocked people was the 18.23 billion yuan fine that the government slapped on Alibaba, citing antitrust activities in April of this year. After that, we saw the party suspend the ride-hailing app DiDi for cybersecurity concerns. And that was just days after it IPOed in the U.S. And these were followed by bans on for-profit tutoring, restrictions on time spent gaming for teenagers and additional antitrust crackdowns on other big tech and e-commerce giants.
So, the why: This year marks the 100-year anniversary of the Communist Party of China. In 1921, the party created a goal for the following 100 years to attain what they called modern prosperity for the citizens of their country. And I think that they achieved that. We saw the country grow from an industrial economy to a consumer-driven economy, and they’ve become a global superpower.
Now, the new goal is common prosperity. This is now the idea of evening the playing field between lower and upper income earners. And closing that gap should allow all citizens, not just the richest ones, equal access to the same opportunities and resources.
To accomplish this goal, though, the government is using regulation to push both human and financial capital toward the areas that will best help support this idea of common prosperity. Jim, did I miss anything in there?
Jim Lowell: Well, it’s a big topic, Liz. I think you covered it well. Even if you just take a step back and think of our trade relations with China, they don’t just span this year, or the last decade, not even the last 100 years. You have to go back a few hundred years to where China trade began, really, out of Boston and New York. And it’s always been contentious, perhaps never more so than currently for the reasons you pointed out.
That whole theme of common prosperity, I would say, finds reverberations here at home as well in terms of our pursuit of a greater sense and sensibility regarding the quality of all of our citizens. But for China, the goal of common prosperity is driven by the Politburo and their machinations, which can be downright draconian, and certainly can spook the market on any given day.
You mentioned Alibaba. We know that they’ve now pledged $15.5 billion, which is the equivalent of two-thirds of its net income in 2020, to support China leader Xi Jinping’s call for a common prosperity. We know Pinduoduo, another e-commerce company, pledged $1.5 billion to farmers. This is corporate executives and companies trying to deal with the new reality that China’s politburo is going to remain, we think, focused on greater control of who prospers within the company and a greater transference of that prosperity for what they believe is the common good. Whether that’s for the market’s good is still anyone’s guess.
Although, we don’t have to guess overly much because just yesterday we saw the market react fairly steeply and suddenly. And what that does is serve as a reminder to all of us in the investment business that what happens in China no longer stays in China.
Jeff DeMaso: Okay. So I get the long term of why in this common prosperity. I mean, Jim, you alluded to the market falling. How much economic and market fallout is China willing to accept in the near term to achieve this long-term goal?
Jim Lowell: That’s a really good question, Jeff. And of course, you and I know time will have to tell us the full tale, but it looks at least as if currently the regime is accelerating, not decelerating, in terms of their approach to greater control of greater companies, greater sectors within their marketplace. And they can afford to do whatever they want given that they are a communist country in complete control of the citizenry and of their own investor class.
My sense is that China can stay draconian perhaps longer than some markets can stay solvent, to paraphrase John Maynard Keynes. But it’s important from an investment standpoint to remember a couple of things. One, the handful of companies that China has been going after doesn’t represent their whole marketplace. In fact, their whole marketplace numbers more than 1,500 stocks, and so far, targeted, let’s say, it’s maybe a baker’s dozen. And so there’s a baby being thrown out with bathwater syndrome going on across China’s market. But as I said, what happens in China doesn’t stay in China.
China’s consumer is, in particular, a large factor in terms of, let’s say, retailers that export into China. And so it doesn’t have to be a Chinese stock company to get riled and roiled by what the Chinese government is doing and what the toll may or may not be on their consumer. Ultimately, one would think that it’s in their political self-interest to ensure economic prosperity, not just common prosperity. And I’m sure they’re convinced that that’s what they’re doing. Or if anybody raises their hand and says something to the contrary, they may go off to a reeducation camp and come back all smiles.
So, anyone’s guess how long they’re willing to pursue this particular line of crackdown. But I would say they’re probably going to pursue it for some time to come. So we have to get used to the volatility that it engenders, not just in their marketplace, but the global marketplace and our own.
Jeff DeMaso: Well, Jim, a few threads I want to pull on there. Let’s maybe come back to that idea of the global companies and how they’re being impacted by what’s going on in China. Because when I hear you talk about crackdowns and reeducation camps and government controls, it makes it sound scary to invest in China, like maybe it’s something that we should just avoid.
Jim Lowell: Well, in today’s morning note to everyone, we talked about how on any given day, it may feel like the biggest risk of all is to invest in China, but 10 years from now, the biggest risk may have been avoiding doing so. And it doesn’t feel like that applies obviously to our markets today because our markets have been enjoying relative strength. But it doesn’t go without saying, on the days when our market feels like the wrong place to be invested, the same 10-year metric applies—the biggest risk would be, at least in our opinion, not investing for the long term.
But we’re not backing up the cart in terms of loading up on China’s stocks. And Liz could certainly weigh in on this as well. And in fact, the managers that we have the highest conviction in who do have some outright China holdings do so in fairly small and very well-reasoned measure.
Of course, we’re also cognizant of the fact that the lion’s share of the companies that we invest in, U.S. multinationals, U.S. companies, have China exposure to them just by the nature of the businesses that they’re in. So even if you were looking at your portfolio and didn’t see any Chinese stock named inside of your portfolio, it wouldn’t mean that you wouldn’t have exposure to what’s going on in China for both risk and reward results.
So Liz, jump in and talk about how you see this particular question being better answered than I just did.
Liz Laprade: No, I mean, I definitely agree with you. The space shouldn’t be avoided entirely. And in fact, now is probably a good time to be thinking about adding some China exposure, as most stocks are probably trading at steep discounts. But with all the volatility that we’ve all been talking about so far, the best way to get into the market right now, I would say, as you alluded to, Jim, is active management. Right?
In a time like this, where policies and regulation changes are happening so quickly, you want a portfolio manager who, one, has boots on the ground there, and who also understands how to navigate these changes. Someone who can still find opportunities as good companies sell off, but also can find new companies that will benefit from the economic and cultural changes the government is really pushing for.
I think that right now, honestly, would be a very tough time to try and be a passive investor in this space. As regulation and policy changes continue, I think that there will be this separation of winners and losers. And in my mind, that’s divided into who are the companies that can adapt to work with the party to achieve better equality and those who just won’t?
Jeff DeMaso: That’s great. So it sounds like I’m hearing: Don’t avoid China entirely. And I always come back to the thought that we look back at bear markets as buying opportunities. And China’s in a bear market, so maybe one day we’ll look back at today as a buying opportunity.
But Jim alluded to the idea that what happens in China doesn’t just stay in China—the rest of the world is impacted. Liz, you were talking about this the other day related to some of the luxury good companies in Europe. What are you seeing there and how are global markets reacting?
Liz Laprade: It’s definitely a good point because it really isn’t just China that’s being adversely affected right now. So far this year, both the U.S. and European markets have been sensitive to news out of China.
For example, a lot of the luxury good companies in Europe have been selling off as the party pushes for closing the wealth gap. Because if you think about it, if wealthy Chinese consumers are put in a position to have to scale back on spending, this could really negatively impact the revenues of European brands like Louis Vuitton or Kering, which owns brands like Gucci and Yves Saint Laurent and others, who all have large customer bases in China.
There was also some fear, if you want to talk about the U.S., of China delisting their companies from U.S. exchanges, which would definitely create some chaos for U.S. investors and a narrower market for Chinese companies that are looking to raise capital. So it’s really affecting all parts of the globe.
Jim Lowell: Can I follow along with Liz on that? Because I know we were talking about this theme. Yesterday, when the markets—especially early in the day, when all the markets were basically rippling through what would be sort of a pulse of panic, but hardly a right panic—we still haven’t had a 5% correction in our own market, certainly didn’t yesterday. And by today, basically back to flat. But we were looking at, in that moment, whether our bond positioning, our allocation into more defensive assets held up in that nanosecond of true flight to safety. And the good news is that they did. Our long-term Treasurys had a very good, positive response.
Those proponents clamoring about how bitcoin is the better alternative had their head handed to them. And of course, for those who keep thinking that China’s currency is going to surpass the U.S. dollar as the locus of strength—it paled in comparison in that nanosecond of a correcting market. So at least we like to see our defensive bulwarks holding up when we expect them to do so. And for a flash in that pan, they did so.
Jeff DeMaso: It speaks to our belief in being diversified. Even if we see opportunity in one part of the globe, we’re not going to just completely go in on that one spot. If there is anything we’ve learned, whether it was the coronavirus or China suddenly changing the rules on companies and their ability to be profitable companies, it’s that the risks you don’t see coming can really send markets for a bit of a loop.
Liz Laprade: Absolutely right. For somebody who spends a lot of time crossing a long stretch of water called Buzzards Bay for a reason, it’s the wave you don’t see that you’ve got to remain constantly vigilant about.
Jeff DeMaso: Yeah. It’s hard to think that China could be an unforeseen risk for investors. Although, we did get hit with some unforeseen regulation risk coming, definitely swamped a few boats. But again, that’s why we try and stay diversified. That’s why we lean on active managers who have expertise in these different markets and can capitalize on opportunities and risks that they see—in addition to our overall risk-aware approach of balancing portfolios for both needs for growth as well as worrying about the downside.
We’ve covered a lot of ground on China. It sounds to me like not a place to avoid, but maybe approach with caution. And with that, this has been Jeff DeMaso, Jim Lowell and Liz Laprade from Adviser Investments.
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