No, we still believe China remains an important exposure for investment portfolios. However, US-China tensions will continue to escalate. Investors need to reaffirm both the rationale and implementation of their China investment strategy and must communicate this with key stakeholders.
Given the above, investors are right to reassess their China exposure and make sure they are comfortable with how they are positioned. For instance, some private investment and venture capital strategies may be more vulnerable to cross-border investment restrictions, while certain public companies may be more exposed to the US market or suppliers. Having conversations with investment managers on how they are assessing portfolio company risk can help build confidence in the chosen investment strategy.These moves have rightfully spooked markets in recent days and raised the specter of further curbs on Chinese investment in the United States and US investment in China. Such policies are gaining bipartisan support in the United States, and being seen as “tough on China” will be a key theme for both candidates during the US presidential election. This increases the chances of President Trump launching aggressive anti-China policies, especially if the economy does not recover quickly or he begins to trail the Democratic challenger in the polls; if facing an electoral loss, why not go all out?US-China relations have arguably sunk to their lowest levels since the 1970s. The Trump administration has openly discussed seeking reparations from China for the global spread of the coronavirus and has threatened to reverse the Phase One trade deal stuck in January. The administration has also blocked the $600 billion Federal Thrift Savings Plan pension fund for US federal workers from investing in Chinese equities. Ominously, one of the cited rationales was the risk of potential US government sanctions on China, highlighting a shift from trade war to financial war. On cue, last Friday the US government announced new export curbs on semiconductor sales to Huawei.
Some may ask, “Why invest in China at all?” A key reason to continue to invest in China is global diversification. China is the second-largest economy in the world and will continue to be an engine of global growth going forward, even in a so-called de-globalized world. The perception that China is dependent on US trade is misplaced; exports to the United States account for less than 4% of Chinese GDP. It is the domestic economy and increasingly the service sector that drives China, and this market is simply too large to ignore. Furthermore, Chinese assets are less correlated to global markets. Ironically, China has been a relative safe haven this year, with both the stock market and currency proving resilient during the March meltdown.
More importantly, as we highlighted in our 2020 Outlook, US policies may backfire and starve the US economy of capital when it remains reliant on foreign investors to fund its current account deficit and now rapidly ballooning fiscal deficit. In the financial war, the cards are stacked against the United States; China owns $1.1 trillion dollars of US government debt, while US investors only own an estimated $200 billion of onshore Chinese equities and bonds. US multinationals are also at risk; according to Gavekal Research, US companies and affiliates generate around $450 billion in sales in China, while some US semiconductor firms generate 40%–60% of their revenue in China. Any “decoupling” from China will not be easy or painless for the United States.
US investors are also key holders of US-listed China stocks, meaning forced delisting or divesting will hurt US (and global investors) more than Chinese investors. This should give the US government pause in enacting such measures. Furthermore, last year China tech giant Alibaba issued a secondary listing in Hong Kong to hedge its US risk, while JD.com has filed to do the same and other Chinese companies may follow suit. At the same time, China is reforming its domestic IPO markets to boost their appeal to start ups. Thus, the United States’ shutting out Chinese companies may not be devastating, and ironically will redirect global investment flows away from the United States and toward China and Hong Kong. Meanwhile, China continues to open the door for foreign investors, announcing this month that it will remove quotas and simplify the process of repatriating capital for qualified foreign institutional investors.
Ultimately, each investor must decide whether investing in China is worth the risk, especially since US-China tensions will remain elevated. We continue to believe the diversification benefits and return potential of investing in China remain attractive today, especially considering the growing vulnerabilities of the US fiscal position and the US dollar. But investors should reaffirm both the rationale and implementation of their China investment strategy and communicate this with key stakeholders.
For further reading, please see the “Decoupling” section of Celia Dallas and Wade O’Brien’s “VantagePoint: Disruption, Demographics, and Decoupling,” Cambridge Associates LLC, January 2020, and also Sean Duffin’s “Benefits of Global Diversification,” Cambridge Associates LLC, April 2020.