It is unclear how China’s relations with the West will evolve in the coming months, but we already know investor capital is at risk not only of derating due to increased regulation by the Chinese government but also of impairment as a consequence of Western sanctions should diplomatic relations turn sour. This has a major impact on the role of China as an asset class – and as a result, on our Secular Outlook.
It has been a challenging 12 months for our strategic allocation in Chinese equities. Of course, short-term underperformance tells one part of the story, but this was never the main driver when considering the secular case for the asset class – as outlined in our recent Secular Outlook 2022.
In the past five years, i.e. ever since we raised Chinese equities to stand-alone allocation status, they have actually outperformed in only two of them – and they are struggling again this year.
Changing our outlook – two factors at play
There were essentially two main factors that kept us convinced up until very recently that Chinese equities, as well as other Chinese instruments such as government bonds, would rise to become a core asset class in globally diversified portfolios.
- The first was China’s unmistakable potential to rise to the levels of technological innovation and corporate profitability previously only reached by the US.
- The second was the increasing diversification benefits in a bipolar world where the US and China lead the global economy but do so in substantially different economic, financial, and technological ecosystems.
From Silicon Valley to common prosperity
In early July 2021, state regulators outright banned one of China’s leading ride-hailing apps following its initial public offering in the US, citing data security concerns. Later that month, private education platforms were forced to go non-profit.
The scrutiny of large information technology companies and their rising monopolistic powers had been increasing for months, but the extent of the measures applied and the subsequent regulatory crackdown on the wider internet sector made it very clear that the US corporate growth model was no longer welcome. Instead, the governing party shifted its strategy towards ‘common prosperity’, with the objective of tackling the country’s rising inequalities and building a social safety net.
We entered 2022 still upholding the potential of Chinese assets to hold a crucial strategic role in portfolios given their second major benefit, diversification. Alas, we did not have to wait long for the next geopolitical shock to turn the Chinese secular outlook on its head.
From diversification benefit to confiscation risk
It would be hard to overstate the geopolitical, economic, and financial ramifications of the Russian invasion of Ukraine on 24 February 2022. The war itself is already a large enough shock, but the strong rallying of Western governments and their corporate sectors behind measures intended to punish Russia’s government is completely unprecedented.
These swords of Damocles hang dangerously over the Chinese economy and its capital markets.
This signals a strong shift in US and European geopolitical and economic strategies going forward, including further ‘weaponisation’ of financial, trade, and business relations as well as the diversification and onshoring of key resources – most critically, in the areas of energy, food, defence, and technology.
These swords of Damocles hang dangerously over the Chinese economy and its capital markets. Indeed, not only is the Middle Kingdom arguably the biggest winner of the globalisation and financialisation trends of the neoliberal era, but the stakes of a strategic confrontation with the US have just become much higher.
China – no longer a core asset class
Any strategic diversification comes at the cost of having the investment’s value marked down hard by Western politicians and regulators should diplomatic relations worsen.
In light of this, we have decided to update our Secular Outlook and put an end to our five-year-old call on Chinese equities rising to core asset class status.
We believe China's investment case is best described as belonging to the larger Asia-excluding-Japan complex.
Going forward, we do not see the asset class as occupying a stand-alone, dedicated allocation within our strategic grids. Instead, we believe its investment case is best described as belonging to the larger Asia-excluding-Japan complex.
In short, the Chinese equity market remains investable but does not warrant a specific strategic allocation due to expected higher returns or better diversification characteristics. This, however, does not exclude the possibility that future tactical or thematic opportunities could be taken within the Chinese market.