Summary: China, the world’s second largest economy, offers opportunities and risks as its authoritarian government tightens its control on Chinese businesses. Our philosophy is that diversification is the antidote to uncertainty. We are comfortable with a small weight to China.
The Chinese and the Hong Kong stock markets have experienced heightened volatility of late as the Communist Party rulers have started to put in place a new model that prioritizes “common prosperity, national security and stability over uninhibited growth and capitalism”1.
The first sign of government intervention started last November when regulators for the Shanghai Stock Exchange halted the initial public stock offering of Ant Group, an affiliate of Alibaba, citing a lack of reporting on major issues regarding ‘changes in the financial technology regulatory environment’. This coincided with disparaging comments from Ant Group about how Chinese banks act as ‘pawnshops’ and alleging that there is no risk in the Chinese financial system. This halt was seen by experts as an act by regulators to maintain the status quo rather than allowing unfettered change in financial technology.
Since November, other Chinese industries including property developers, crypto miners, technology, and tutoring firms have all come under heightened scrutiny and radical rule changes all in the name of the three objectives of “common prosperity, national security and stability”.
China’s internet tech sector, represented by companies including TenCent, Meituan, and Alibaba, has been investigated by the Chinese government for such issues as data usage and employment practices as it wants to, in its view, clean up the sector. In April, China imposed a $2.8 billion fine against Alibaba for what it says was anticompetitive behavior. The sector has also been affected by the possibility of Chinese stocks being delisted from U.S. stock exchanges as the SEC said it is taking initial steps to force accounting firms to let U.S. regulators review the financial audits of overseas companies. China has continued to refuse to let the PCAOB examine audits of Chinese companies citing national security concerns.
Most recently, for-profit tutoring companies lost more than half their value after Beijing’s decision to order these companies to become non-profits in the name of easing the financial burden for school-age parents (common prosperity).
Investors are left wondering what industry will be the next to come under the government microscope. Meanwhile last week, China sought to ease investor concerns about these crackdowns by telling firms that they will consider market impact before introducing new policies.
In general, our exposure to companies in China comes through the ownership of exchange-traded funds. One such example is the Schwab Emerging Markets Equity ETF (ticker: SCHE). At the end of July, SCHE held 38% in China and Hong Kong. For a portfolio with 10% in emerging market equities, Chinese stocks represented approximately 3-4% of the total portfolio. SCHE owns over 700 companies in China and Hong Kong, most of which have not been excoriated. The government’s actions and the attention they have raised, has caused increased volatility in both China and emerging markets generally.
While concerning, the recent actions by the government of China are typical of the political and regulatory risks associated with investing in emerging markets. In the face of such risks, investors should expect higher returns and that is our expectation over the long term. China is the second largest economy behind the United States and is projected by many to be the largest within 10 years. Investment opportunities and the search for economic growth will continue to lead investors to China despite the added risks.
Disclosures: The analysis in this report has been prepared by Red Tortoise LLC utilizing data from third parties. Reasonable care has been taken to assure the accuracy of the data contained herein and comments are objectively stated and are based on facts gathered in good faith; however, Red Tortoise cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Red Tortoise disclaims responsibility, financial or otherwise, for the accuracy or completeness of this report. Opinions expressed in these reports may change without prior notice and Red Tortoise is under no obligation to update the information to reflect changes after the publication date.
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