Emerging Markets Investing: The Problem of China - 3Q15

Through the first five months of 2015, the Shanghai A-Shares were booming. Between January 1 and June 12, the Shanghai Composite Index grew by 60 percent to a seven-year high. Since that peak, the Shanghai A-Shares have experienced a significant downdraft of 25 percent through July 10. This volatile market demonstrates the real problem of investing in China. Western investors are not accustomed to the lack of market transparency, and yet Chinese growth potential as a component of world GDP demands attention. Investors face the difficult task of investing with confidence in a highly volatile market they are not sure is trustworthy, while reconciling these risks with the importance of the massive Chinese economy.

China Markets and the Individual Investor

Since 2010, the Chinese government has been setting policies to encourage stock market investment. China’s purpose is to speed the transition from an export economy to a consumer-driven economy. While they have used numerous devices to accomplish their goal, perhaps the biggest impact was through loosening requirements for margin-financing or borrowing money to invest. This opened the door for more individuals to invest, such that about 85 percent of all investors in China are individuals, not financial professionals. While dollars poured into the market and the prices of stocks rose, these individual investors used more and more margin to get in at the market highs, believing perhaps that markets could only move in one direction. Neighbors followed friends into the market, and family followed family.

Rather than working to curb this behavior, China’s central planners hoped the stock gains could be used by state-owned enterprises to pay down company debt. The idea of using the stock markets to finance state-owned enterprises is dangerous in principle unless the stock market can only move in one direction. As long as stocks go up, the idea works, but the outcome is less likely considering the reality of market cycles, valuation excess, and other forces that still apply despite China’s governmental attempts to control the market.

This spring, Chinese stocks rose rapidly. Most of the growth occurred in names not included in the MSCI Emerging Markets Index or available to U.S. investors. As the market reached dizzying heights in terms of valuations, the Chinese government sought to use some central policy shifts to temper the market. The government sought to use central banking strategies to slow growth without disrupting overall economic health. However, tightening the cash supply caused some confusion amongst individual investors. With the same herd mentality that fueled the run-up, many individual investors began to pull out of the market.

The precipitous drop of 30 percent caused governmental concern and an adjustment to policy, after as many as 1,400 stocks stopped trading due to out-sized losses. While there are circuit breaker-type trading restrictions in the U.S., this was direct government intervention. Additional policies included forbidding large institutional investors from selling certain securities for six months. It appears likely that similar restrictions on individual investors could be lifted sooner. The new policy called for a loosening of the cash supply to re-encourage investment. When this did not work, the government politely suggested that everyone invest for patriotic reasons. When this did not work either, they ordered state-owned enterprises to invest in the market along with the government. Market declines were contained. We are now left wondering if the volatility were to resume, which way it would go. While it is difficult for most U.S. investors to participate directly in the Shanghai Composite Index companies, the general direction of the Chinese markets is captured in the Hang Seng Index, which is open to fund managers.

China Markets Matter

Understanding what happened in the Chinese markets in 2015 is educational, though many investors wonder why it ultimately matters. China’s contribution to global growth is significant as the world’s second largest economy and because of strong long-term growth rates. Accordingly, the economics of China is very important. One challenge investors face is that market behavior is not as closely correlated to the economy in China as it is in the U.S. and other economies. Still, it is worth noting that the consensus view on economic growth in China, even after the recent stock market declines, is a 4 percent expansion. The consensus view on the U.S .economy is only 2 percent. China is expected to maintain strong economic growth, eventually taking over as the world’s top economy. The Chinese government has a plan that calls for a growth rate of 7 percent, and while that state-sponsored bogey might be hard to hit, it should indicate to investors a willingness on the part of the Chinese government to continue fueling the growth engine. However, as with all volatile markets, there will be times of cyclical advances and declines as the market grows in size and importance.

How to Invest

There are essentially two methods for Americans to invest directly in China. While the Shanghai Composite Index is mostly unavailable, the Hang Seng Index offers exposure to some of China’s largest companies. Both passively managed index strategies and active strategies use this exposure to China. However, each investment strategy yields starkly different results, of which 2014 into 2015 was an excellent example. While the Chinese markets ran up quickly, passive strategies participated and increased weightings to the markets as the index grew. Meanwhile, active strategies became increasingly leery of the run-up and remained underweight to China. Consequently, passive strategies captured more market returns through June until the decline occurred. Active strategies fared better defending portfolios during the decline. Deciding the most prescient investment strategy is a matter for investment committees as they budget for risk. Knowing full well that the allocation to China should likely grow as the market grows, it becomes imperative to measure the risk and reward relationship. Measured involvement with a good understanding of the nature of the Chinese markets, aligned with long-term investment goals, is likely the best guidepost to use when deciding how to invest in China.

For more information, please contact your Fifth Third Bank Client Consultant.

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