These Days, Institutional Investors Eye China Warily
U.S. and Canadian allocators no longer pile into Chinese assets.
Art by Jia Liu
China is a fast-growing giant, destined to be the world’s economic leader, and investing in it is a must. China is a despotic rogue state with no regard for the rule of law and big underlying problems that threaten its growth, so investing there is iffy. Those competing narratives are tugging at North American asset allocators nowadays.
Such less-than-glowing views of the world’s second largest economy and its investments stand in stark contrast to China’s golden allure not that long ago.
The issue today is how many of the new qualms about the place are temporary, due to recent turbulence, as opposed to permanent, born of the hard-headed realism that China might not be an investment nirvana after all. As China has struggled under its COVID-19 lockdown , which Beijing recently lifted, foreign direct investment has fallen off rapidly, Rhodium Group statistics show, with inflows in last year’s third quarter down 30%, compared with the first period’s $60 billion.
Beyond that looms the matter of whether China will continue to grow in economic strength and surpass the U.S.’s gross domestic product. Is that outcome inevitable? After all, another expanding Asian power, once seen as destined to eclipse the U.S., has faded. That, of course, would be Japan.
Change in Tempo
China’s astounding GDP expansion was possible because it started from a low base, and now those enormous gains have become more muted, a familiar template as economies mature. Looked at another way, says Rob Almeida, global investment strategist at MFS Investment Management, China “has exhausted its growth model,” although its pace still outdoes other major nations.
Markets have reflected the change in tempo. Chinese investments have encountered a bumpy road of late, with the Shanghai Composite Index sliding 15% in 2022. At least the Chinese index didn’t lose as much as the S&P 500, down 19% last year. And it has blipped up in recent weeks with the ending of the pandemic restrictions.
Time out here for a sobering reality check to put things in context: In historical terms, the China investing fad does not look that clever. For a long time, U.S. stocks have far overshadowed Chinese shares’ performances. Right before the global financial crisis, Chinese stocks soared. They since have shed almost 40% of their value, while its American counterparts have quadrupled in worth. Since the crisis, Chinese stock rallies fizzled before they could overtake American equities other than briefly. “They tried to get there in 2015 and 2021, and fell short,” observes Huntington Private Bank’s CIO, John Augustine.
How Allocators Differ
As a result, the case for investing in China these days boils down to one of diversification, rendering its stocks and bonds worthy additions to a portfolio, but not must-haves. Nobody now is seeking to make a big score with the hottest growth story on the planet.
Opinions differ as to just what Chinese assets to invest in. A large body of thought favors China’s tech businesses, especially those oriented toward consumers, such as online commerce giant Alibaba, social media and video-gaming company Tencent and search-engine provider Baidu. Those are better bets than government-owned outfits, which are subject to political interference, suggests Kevin Carter, CIO and founder of investment manager EMQQ Global, which focuses on emerging markets.
The overall watchword for investors nowadays is to approach China with caution, advises Steffen Reichold, chief EM economist at Stone Harbor Investment Partners. He points to a number of significant impediments: foreigners’ limited access to China’s markets; the nation’s weak property rights; U.S. sanctions (several dozen Chinese companies are on Washington’s blacklist, hindering them from buying American technology); and the lack of transparency of many domestic Chinese companies. To be sure, China has agreed to divulge more financial details of its companies listed in the U.S.
Yes, China could well be starting to recover now that COVID-19 restrictions are lifted, says Reichold. In the meantime, this possibility has failed to excite institutional investors, who doubt there will be much of an explosive gain from China. They mostly are content to bide their time and see what happens.
Allocators don’t usually display political or other subjective opinions in explaining their investment policy moves. Any policy shifts are often explained in the briefest terms. A prime example is the State Board of Administration of Florida, whose board of trustees voted in April 2022 to stop making new investments in China while it continues to assess the risks.
The board chose not to increase the positions due to “increasing risks and uncertainty,” Lamar Taylor, the interim executive director and CIO, said at the time. Previously, the board had discussed China’s rickety real estate market and its government crackdown on Chinese tech companies.
The organization’s last annual report, as of June 2022, did not state all its holdings, Chinese or otherwise, but did list several China-oriented mutual funds: BlackRock China A shares ($226 million), William Blair China A shares ($236 million) and Warburg Pincus China ($102 million).
Florida Governor Ron DeSantis, who chairs the SBA board, has been an outspoken critic of China and insisted that the agency conduct a survey of its investments in the country. The survey indicated that Chinese assets were about 3% of the Florida program’s total, and the board’s vote to stop further investment came within weeks.
Meanwhile, the CPPIB added to its new China assets by a small amount recently, but it remained unclear if that was offset by any sale of other holdings. As of March 2022, the end of the CPPIB’s fiscal year, its China investments totaled C$56 billion (US$42 billion). It has substantial public equity holdings in Alibaba, China Gas Holdings, Postal Savings Bank of China and Tencent.
In late 2022, despite all the controversy over China, the CPPIB invested US$184 million in the Hong Kong initial public offering of China Tourism Group Duty Free, a leading travel merchandiser with 193 stores in airports, cruise ships and downtown areas. It would not discuss the rationale for this particular move.
In its 2022 annual report, the CPPIB did acknowledge that Chinese investments had been a drag on performance, albeit to a minor extent, citing “losses in emerging markets … predominantly driven by investments in China.” The fund returned 1.3% in fiscal 2022, down from the previous year’s 20%, which came amid a much stronger market.
In September 2022, the Texas Teachers board of trustees voted to halve its China exposure, but it styled the shrinkage as diversification. At its meeting, one official said the fund “needed more balance.” Not a word was spoken about Chinese policies, or China assets’ strengths or weaknesses.
The Texas Teachers allocations were guided by China’s place in a well-followed index. The fund’s emerging market benchmark, the MSCI EM index, has long kept China’s portion at a little more than one-third (oddly, China is still classified as an EM), and thus the Texas program did, as well. At this level, China was 3% of the fund’s entire portfolio. By reducing the China stake, the plan brought that down to 1.5%. For all of 2022, the MSCI index without China lost 19.2%; the China index was worse, yet not overwhelmingly so, down 21.9%.
China’s Trajectory
The U.S. economy is projected to have grown just 1.8% in 2022 and, amid economic woes, will increase just 0.5% this year and 1.0% in 2024, says the Organization for Economic Co-operation and Development. China should do better, but nothing like the double-digit rate it enjoyed in years past: 3% in 2022, then inching up to 4.6% and 4.1% over the following two years. China’s GDP, according to the World Bank, is $17.7 trillion, with the United States economy slightly more than $2.1 trillion.
China has enjoyed a spectacular ascent since it joined the World Trade Organization in 2001, even counting the recent deceleration, and it is expected to continue out-running others. No wonder Goldman Sachs predicts that China’s gross domestic product will overtake the U.S. economy by 2035.
The remarkable growth of the Chinese economy, despite its 2022 stumble due to the strict pandemic lockdown, continues to show potential—and investors are wise to invest in it, argues Matt Lloyd, chief investment strategist at Advisors Asset Management. “They will be a world power, and in 20 years a bigger economy” than America’s, he says, adding that considerable headwinds could slow the Asian colossus. China suffers from problems that won’t go away, like its aging population and debt-crippled housing system.
Aside from U.S. resolve to stand by Taiwan, which Beijing threatens to invade, flashpoints between the two nations are few. At this point, America and China “have an indirect geopolitical competition,” says Seamus Smyth, chief economist at Virtus Investment Partners. China aspires to tech leadership, for instance, yet has a long way to go to draw anywhere close to the U.S., home to Microsoft, Apple, Cisco Systems and on and on.
Military clashes between the two nations, however, cannot be ruled out. Hot-headed human emotions can prevail over calm economic analysis. One pessimistic school of thought: If the world has two rival superpowers, they are bound to go to war. While such a gargantuan conflict, reminiscent of the early 1940s, could set back China’s quest to be a prosperous nation, dictatorships operate under different norms than democracies do.
Harvard scholar Graham Allison calls this “the Thucydides Trap,” named after the ancient Greek historian, who averred that up-and-comer Sparta, in the 5th century B.C., was bound to militarily challenge Greece’s dominant city-state, Athens. In his book about U.S.-China relations, Destined for War, Allison warns of “a deadly pattern of structural stress that results when a rising power challenges a ruling one,” which stretches from classical times to the recent past, when Germany went to war twice in the 20thh century.
To China bears, the regime’s indifference to the rule of law is a major red flag for investors. “Does anyone say: ‘So what if I can’t get my money out of China’?” remarks Fiduciary Trust’s CIO, Hans Olsen, reasoning that the returns from Chinese investment are not sufficient to offset the chance that Beijing will confiscate their assets. “No one is paid enough to take that risk.”
Nonetheless, if China does overtake the U.S. economically, what difference would it make? “At least, the Chinese would have bragging rights,” says Frank Rybinski, chief macros strategist at Aegon Asset Management. Just the same, becoming No. 1 in GDP still leaves China way behind in terms of per capita wealth, he adds. The extent of its poverty and the now-slowing expansion of its middle class are hurdles to any improvement.
Using that gauge shows that China has a long way to go. While it dwarfs the U.S in terms of population (1.4 billion versus 333 million), Chinese GDP per capita is just one-fifth of the U.S.’s, observes economist Gary Shilling, head of his eponymous research and investing firm. Comparing growth rates for each nation’s GDP per capita measure, he calculates, means China would possibly overtake America in 109 years, rather than 12, as in the Goldman model.
The Last Word
All right, is China a worthwhile destination for investments?
True, it remains an economic powerhouse. “The world still needs China’s goods,” says Alison Adams, executive vice president at Meketa Investment Group.
Yet those other worrisome factors intrude. Investors in its securities, she goes on, can be “optimistic over the short term, but there are questions over the long term.”
The upshot is that many institutional investors are well aware of these realities as they plan for the future. They may not be bailing out, but the thrill is gone.
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