July 6, 2022

Will US Allocators Stay the Course on Chinese Investments?

China’s drawbacks are prompting some hard thinking among American institutions, but the country’s allure remains potent.

Reported by Larry Light

Art by Alex Eben Meyer

China can be treacherous turf for investors. Political turbulence looms large—over trade, Russia, Taiwan, human rights violations, and the government’s attacks on successful businesses. Plus, a COVID-19 outbreak has hindered the Chinese economy, at least for now. But for a number of institutions, investing there makes sense because China’s growth rate remains much more rapid than that of the U.S., the world’s largest economy.

The question is: How much longer and stronger will allocators’ China commitments be? Will they up their ante, stand pat or pull back? “We don’t have a crystal ball, but we are holding close to the benchmark,” says Marcus Frampton, CIO of the Alaska Permanent Fund. His reference: China’s 3% share of the MSCI All World Index.

Alaska Permanent has money in public stocks and private equity/venture capital in China. Frampton says his portfolio managers “like the valuations and fundamentals on China.” Geopolitical considerations, he goes on, have convinced the fund to hold steady.

“Effectively, we don’t want to bet on China outperforming or underperforming,” he explains. “Asset valuations in isolation, not factoring in geopolitics, appear more attractive in China than in the U.S. right now.”

The growth of China’s gross domestic product, the globe’s second largest, has eclipsed the U.S.’s every year for the past four decades, with projections that the Middle Kingdom will take the lead in coming years. The World Bank expects Beijing’s tough stance on private companies to have hindered GDP expansion (to an estimated 4.3% in 2022, from 8.1% last year). Regardless, for the U.S., GDP growth this year is expected to be 2.9%, and that’s likely getting revised down due to recession worries.

FOMO, China Version

Small wonder that U.S. institutional investors “have had China exposure for a long time,” says Brendan Ahern, CIO of KraneShares, which has a collection of China-focused exchange-traded funds. “They’re looking for growth stocks.”

For allocators, FOMO, or fear of missing out, has been the overwhelming dynamic driving their China investing. “China has a booming consumer class,” says Kevin Carter, CIO of EMQQ Global, which sponsors a fund dedicated to emerging markets’ web and e-commerce enterprises. (China makes up around half of its assets.)

At the same time, however, ambivalence toward China as an investment destination is rife among U.S allocators. The California State Teachers’ Retirement System has 3% of its assets in China, with almost 200 stocks as of 2021. Yet Chris Ailman, the CalSTRS CIO, has described investing there as “a conundrum.” He mentioned environmental, social, and governance concerns and fears that outside investors are indirectly funding China’s armed forces.

The upshot is that American investors, chiefly institutions, have lately been dialing back fresh commitments to Chinese companies, according to Steven Shen, manager of quantitative strategy at research outfit EPFR Global. In January, China-centered international equity funds—mutual funds and ETFs—had a $15 billion net inflow; in May, that had turned into a $200 million outflow. And equity funds allocations to China stocks are under 2% this year, down from over 5% in 2020.

But that may well be temporary. The outflows are small. While many allocators underweighted China in the past year or so, Ahern says, “a sense of optimism is returning to Chinese markets.”

Investors, says Burns McKinney, senior portfolio manager at value shop NFJ Investment Group, “have overreacted.” Among other things, Chinese stocks have the virtue of being cheaper than American shares, he argues—with a forward price/earnings ratio of 11, versus a P/E of 16 for American equities. “The Chinese P/E is the lowest we’ve seen in eight years,” he points out.

Fine China

Allocators with significant positions in China include the University of Texas/Texas A&M Investment Management Company, California Public Employees’ Retirement System, and San Francisco Employees’ Retirement System.

In the past, they have poured money into China assets, whether through investment funds or direct investments. UTIMCO, in its report for the January to March 2022 quarter, stated that its investment in the MSCI China Index had lost 19% for the period, but it expected a 20% increase in earnings from it in the coming 12 months.

For inspiration on China investing, U.S. institutions can look to their north. Canadian funds have a storied international effort, and that’s especially true with China. Some 10% of the Canada Pension Plan Investment Board’s assets are in China.

In 2016, the program invested C$1.1 billion (US$844 million) in China’s Tencent Holdings, the online colossus. A spokesman for CPPIB, Canada’s largest pension plan, says, “As a long-term investor, we invest across different sectors and asset classes in China. That diversification has helped cushion us from severe market impacts.”

Two Cheers for Chinese Assets

Some good news for foreign China investors has popped up recently, spurring hope that China is on the way to recovering its mojo. The Shanghai Shenzen CSI 300 Index, which lost a quarter of its value between early 2021 and May of this year, has since regained ground, up 18% over the past two months.

Many China watchers believe that Beijing is bent on revving up the economy in time for the Communist Party leadership’s conclave in the fall. Chinese President Xi Jinping is aiming for a third term, and positive economic news would bolster that.

It’s significant that, as central banks in the U.S., Europe, and Japan are hiking interest rates, the People’s Bank of China is going in the other direction. The PBOC’s policy is widely seen as a bid to support China’s sagging, overbuilt housing industry. This “should help drive a revival in housing sales, which have gone from bad to worse recently,” Julian Evans-Pritchard, senior China economist at Capital Economics, said in a research note.

Signs have appeared that the Beijing regime’s crackdown on privately owned Chinese companies, particularly tech ones, could be abating. In late 2020, investors were shocked when Chinese regulators blocked the initial public offering of Ant Group, an online payment and credit rating company controlled by billionaire Jack Ma. Lately, though, the authorities appear to be open to reviving the IPO.

What’s more, the Biden administration is eyeing removing the tariffs that Donald Trump slapped on Chinese goods. President Joe Biden is primarily motivated by the prospect of lowering the cost of Chinese products to inflation-weary U.S. consumers, but such a move also could lessen Sino-American tensions. Meanwhile, notes KraneShares’ Ahern, “There’s talk of a Biden-Xi summit after the U.S. midterm elections.”

With luck, a longstanding threat to U.S. investors in China, concerning American depositary receipts for Chinese companies, may not come to pass. ADRs allow numerous Chinese companies’ shares to be traded in the U.S.

Congress passed a law requiring that Chinese ADR sponsors comply with American accounting standards by 2024. This mandates that U.S. accounting firms be allowed to examine the companies’ books in China. Non-compliance means that ADRs get booted from U.S. exchanges. China’s accounting standards are looser and less transparent than those in the West, and Beijing doesn’t want outsiders imposing their standards on Chinese companies.

Officials from both governments “are in talks to work this out,” says EMQQ’s Carter. And if that doesn’t happen? Then, he adds, the Chinese businesses will fold their ADRs and American investors will be able to buy them on the Hong Kong exchange. That semi-autonomous Chinese island city’s bourse is more open to foreigners than exchanges on the mainland, but Hong Kong still uses China’s regular bean-counting methods.

Certainly, Chinese rulers play the long game, building up Beijing’s influence with public works in underdeveloped nations and strengthening its military. China fans say investing there is a long-term proposition and patience is a necessity. As the Chinese proverb goes: “The best time to plant a tree was 20 years ago. The second best time is today.”