Our Thoughts On The Current Investability Of China

Summary

• Over the last several years, the Chinese economy has faced self-induced headwinds like monetary and fiscal tightening, a strict regulatory environment, etc.
• Today, the Chinese economy remains weak, and consumers have shown a tremendous reluctance to increase spending.
• The key takeaway here is that while we are comfortable being opportunistic when conditions warrant it, we are also content to pursue more attractive investments elsewhere.

Over the last several years, the Chinese economy has faced self-induced headwinds. These have included:

• Monetary and fiscal tightening
• Strict regulatory environment
• Macroprudential policy aimed at reducing risks in the property market

This has come alongside a deteriorating geopolitical environment and concerted efforts by foreign companies to diversify their supply chains away from China. These factors hit the equity market hard and drove a significant derating of the market from its recent peak price to earnings multiple of roughly 21x in early 2021 down into high single digits earlier this year. Relative performance also suffered tremendously during this time.

Today, the Chinese economy remains weak, and consumers have shown a tremendous reluctance to increase spending. Exports and investments (in particular, property investment) remain challenged for various reasons. Foreign direct investment has reached multi-year lows, and portfolio outflows have reached extreme levels.

Government officials have been slow to respond, but we have seen concrete changes in their approach to the self-inflicted wounds discussed above. Fiscal and monetary policy have turned more stimulative, the regulatory crackdown has largely abated for now, and we have seen measures aimed at supporting the domestic property market. In addition, we have seen policies clearly directed at the country's equity market, including bans on selling at market open and close, and increased buying from state-owned funds.

To us, the question on China's investability is one of risk tolerance. There are reasons to believe that the Chinese market could rebound strongly in what essentially equates to a mean reversion trade, given the extreme levels of positioning and the starting point for valuation. However, this is more of a trade than an investment.

On a longer-term time horizon, we continue to see reasons to be cautious on Chinese equities, including:

• Xi Jinping has proven himself to be more hostile toward capital than previous rulers.
• Geopolitical tensions are structurally rising, even if they may ebb and flow over shorter periods of time.
• Several of the more attractive areas for investment are increasingly in the cross-hair of foreign governments.
• US elections may also prove to be problematic for China.

That being said, China is not a market that we would be comfortable writing off. Indeed, we maintain a position in Tencent and have looked at other names recently. However, the long-term case to invest in China as a Westerner has become less compelling, and there are a growing number of risks that we believe are difficult to forecast. For this reason, despite the incredibly attractive valuations we see in the Chinese market at the moment, we are reluctant to try and pick a bottom and meaningfully overweight Chinese equities.

The key takeaway here is that while we are comfortable being opportunistic when conditions warrant it, we are also content to pursue more attractive investments elsewhere.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.