China Stocks Are No Longer a Sure Thing. Where to Invest Now.


Illustration by John Tomac

For decades, China has been synonymous with fast growth. Multinational companies invested billions in supply chains and production hubs, and catered to the millions of Chinese who climbed out of poverty into a growing middle class. Investors reaped robust returns.

No longer.

This powerful engine of global growth is sputtering, and the economic cooperation that underpinned the U.S.-China relationship is at risk. China’s slump threatens the near-term profits of companies such as



Tesla

(ticker: TSLA) and



Apple

(AAPL), along with mining and other firms that count China as one of their biggest customers. Instead of lifting the global economy, China’s malaise adds to the risk of a global recession.

“For anyone investing in China on the notion this is the growth engine of the world, it’s not so clear-cut,” says Justin Leverenz, manager of the Invesco Developing Markets fund.

Beijing’s bid to create a more level playing field, to focus on data security, and to promote economic equality over profits upended business models of education companies, financial-technology upstarts like Ant Group, and internet behemoths such as



Alibaba Group

(BABA) and



Tencent Holdings

(700.Hong Kong).

Adding to the pressure is increasing U.S. bipartisan support for a tougher stance against China, plus the Securities and Exchange Commission’s plans to delist Chinese companies that don’t fully open up their books. Five state-owned companies, including



PetroChina

(PTR) and



China Petroleum & Chemical

(SNP), decided to voluntarily delist on Aug. 12, sending their shares lower.

Amid the turmoil, the MSCI China index has fallen 50% from its February 2021 high, with many investors reducing stakes in the internet stocks that dominated the index. Bridgewater Associates, the world’s largest hedge fund and a longtime investor in China, sold roughly $1 billion worth of Alibaba,



Bilibili

(BILI),



JD.com

(JD),



NetEase

(NTES), and



DiDi Global

(DIDI), according to a recent filing.

At 10 times 2023 earnings, Chinese stocks are now one of the cheapest pockets of the market—selling at a 40% discount to the


S&P 500 index

and 20% discount to battered European stocks. For some, extreme pessimism means a bottom could be near. But for other money managers, there is too much uncertainty to plunge in now.

“Owning Chinese assets is not something that we’re comfortable with in an aggressive way,” says Jitania Kandhari, head of macro and thematic research for Morgan Stanley Investment Management’s emerging markets equities team.

While Kandhari’s team has long underweighted its China exposure compared with its index benchmark, it has pulled back further amid geopolitical risks and worries about increasing government interference in the private sector.

The risk ratcheted up after China fired ballistic missiles over Taiwan, and stepped up military exercises around the island in response to visits by U.S. congressional delegations this month. China sees Taiwan as part of China and has vowed to take it over, by force if necessary.

Analysts see few signs of an imminent military invasion, in part because China relies on Taiwan for semiconductor chips and needs access to critical technology from the West. But the risk of an incident that spurs a conflict looms. Meanwhile, China’s military drills showcased its ability to implement a blockade of Taiwan that could disrupt a semiconductor hub critical for the global economy.

People line up for Covid-19 testing in China’s southern Hainan province in August.


STR/AFP/Getty Images

The conflict is leading to a reassessment of basic assumptions held by investors and multinational companies, says Jude Blanchette, the Freeman Chair in China Studies at the Center for Strategic and International Studies. “If this was a competition, now it’s very much a rivalry. The echoes of the Cold War are becoming louder, and discussions in Beijing and Washington, D.C., are now about crisis management,” he adds.

China’s flagging economy is also spooking investors. The Communist Party’s power is built on improving living conditions, with rising income and spreading wealth. Now, a generation that grew up with strong growth, rising property prices, and ample opportunity faces an unfamiliar slowdown. Household employment and income expectations have sunk to decade lows, according to the People’s Bank of China urban depositor survey.

China’s strict Covid policies in the early days of the outbreak in 2020 was a source of pride, as China’s economy was one of the few to grow that year. But its zero-Covid approach has turned into a source of economic distress and growing frustration this year as the more transmissible Omicron variant forced cities like Shanghai into a two-month lockdown.

Though China eked out 0.4% growth in the second quarter—far from the 5.5% annual target it set earlier this year—policy makers haven’t meaningfully softened their stance, in part because their healthcare system is ill-equipped to deal with a major outbreak, their vaccine hasn’t been as effective as other versions, and older Chinese have been slow to get vaccinated. The threat of getting stranded because of a Covid outbreak, as 80,000 tourists did on the island of Hainan this month, or locked in a mall for days, has curtailed economic activity.

China’s crackdown on technology sectors created its own strain, with companies like Alibaba, Tencent, and JD.com laying off as much as 15% of their workers, according to Rhodium Group. Roughly one in five 16- to 24-year-olds were out of a job in July, with unemployment nearing 20%.

“The job market is brutal. The start-up scene is not as optimistic as two to three years ago, as funding has stalled. People are taking gig jobs and cutting back on going out,” says Zak Dychtwald, CEO of Young China Group, a research and consulting firm. Dychtwald says the situation is the worst since he started tracking China’s roughly 700 million people under the age of 40 a dozen years ago. That’s reflected in a reduced appetite to borrow money, even as China makes it easier to do so.

The continued slump in the property market also weighs on the economy. Policy makers engineered a slump by cracking down on excess borrowing by property developers to curtail the speculation that had put real estate out of the reach of many in the middle class.

The crackdown turned into a bust. Property prices have fallen for 11 consecutive months, damaging one of the biggest stores of household wealth and a sector that supports roughly 30% of gross domestic product. Developers are defaulting while others suspend construction as financing dries up, triggering mortgage boycotts from homeowners who prepaid for unfinished properties.

People walk in front of a large screen showing a news broadcast about China’s military exercises encircling Taiwan in August.


Noel Celis/AFP/Getty Images

In the past, China responded to economic pain with massive stimulus. But its largess following the global financial crisis left it with a debt hangover. While it has taken steps to stabilize the economy, including its move this past week to cut interest rates, few expect a major stimulus.

That feeds concerns around the current slump. “The longer China is grappling with anemic economic activity, the higher the risk of a destabilizing shock,” says Rory Green, head of China and Asia Research at TS Lombard.

The stakes are especially high for this fall’s 20th Party Congress, the once-in-five-year leadership transition for the Communist Party, which analysts describe as the most consequential conclave of 40 years.

President Xi Jinping, who scrapped term limits in 2018, is still widely expected to secure a norm-busting third term. Robert Daly, director of the Wilson Center’s Kissinger Institute on China and the United States, expects Xi to consolidate power and double down on insularity rather than pivot toward opening the economy.

For some investors, China’s authoritarian turn, including its crackdown on dissents in Hong Kong and human-rights abuses in Xinjiang, makes Chinese stocks off limits. But for other investors, access to China is still of interest, albeit in a more targeted way, as the government bolsters its technological capabilities, and tries to become more self-sufficient.

Chinese stocks now appear attractive compared with the U.S. or Europe. China is stimulating its economy, while much of the rest of the world is raising interest rates and trying to tame inflation. Any steps by Beijing to relax its Covid restrictions after the Party Congress would also lift the market.

But stocks to own for the next phase of China’s evolution are different from those of the last. Matthews Asia Chief Investment Officer Robert Horrocks expects emphasis on what Beijing calls common prosperity after the Party Congress, as the government increases middle-class access to education, property, and financial services.

“We view the line between private and public companies as increasingly blurred and have adjusted our risk and valuation analysis accordingly,” says Howie Schwab, co-manager of the


Driehaus Emerging Markets Growth

(DREGX) fund, which has 22% allocated in China, compared with roughly 30% last year. Schwab is also trying to steer clear of companies at a higher risk of sanctions or geopolitical brinkmanship—which includes technology and some biotech names.

Others, like value-oriented James Donald, a co-manager on the


Lazard Emerging Markets Equity Portfolio

(LZOEX), are bypassing internet behemoths such as Alibaba and Tencent. In August, both companies reported their first quarter of year-over-year revenue declines since going public. “Everyone says they are a bargain, but these companies’ profitability has come down from 35% to 10%. It’s the reason we aren’t buying,” he says.

Rajiv Jain, manager of the


GQG Partners Emerging Markets Equity

(GQGPX) fund, is also rethinking companies with dominant leading positions because it puts them in the crosshairs of Beijing’s antimonopoly drive. Being a strong second- or third- tier player might be a better option.

“Ultimately, it’s not a level playing field. We have a new love for state-owned enterprises,” says Jain, who is gravitating toward companies whose growth is slower but dependable, and are priced accordingly. That includes



China Merchants Bank

(60036.China) and



China Construction Bank

(601939.China).

Matthews’ Horrocks is focusing on the domestic champions that China is trying to build in healthcare, financials, and consumer-oriented sectors. One holding in the


Matthews Asian Growth & Income

(MACSX) fund, where he is the lead manager, is



AIA Group

(1299.Hong Kong), a leading life insurer in Asia with a high-caliber distribution force.

Another area of focus for Horrocks: companies in areas that require elevated levels of research and development, like high-end biomedical and pharmaceutical products. Government intervention, such as price controls, could be counterproductive in those areas, since it could curtail innovation.

Others are gravitating to semiconductor, hardware, and industrial companies that stand to benefit as China tries to reduce its reliance on foreign companies and invests to maintain a leading position in clean technologies. Driehaus’ Schwab has been buying more companies like



Suzhou Maxwell Technologies

(300751.China), which makes equipment for the solar industry.

Philip Wool, who manages the


Rayliant Quantamental China Equity

exchange-traded fund (RAYC), has been looking for cheaper ways to benefit from the focus on renewables, including



YongXing Special Materials Technology

(002756.China), a steel maker that also has a fast-growing lithium carbonate business, which used in electric-vehicle batteries.

Many of the companies that stand to benefit from China’s next phase of growth are domestically-oriented, says Matthews’ Horrocks. And the sectors that excite investors now account for roughly just a quarter of the MSCI China index, according to Morgan Stanley’s Kandhari.

One thing is clear. “Investors need to tread more carefully than in the past,” says Leverenz, the Invesco fund manager.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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