Dropping China?

Adam M. Grossman

WITH 2024’S ELECTION underway, many folks are asking, do politics affect investment markets? On that score, there’s good news: The data say markets in the U.S. have delivered good—and roughly equal—results under both Democrats and Republicans.

But that doesn’t mean politics never has an impact. Look outside the U.S., and you’ll see that a country’s political structure can have enormous implications. To the extent that your portfolio is diversified internationally, it’s important to keep an eye on developments elsewhere. At the top of the list: China, which is now the world’s second-largest economy.

For years, China was attractive to investors because of its rapid economic growth. But things have changed in recent years. Between 2021 and 2023, the MSCI China Index lost more than 18% a year, while the S&P 500 gained 10% annually. Over the past 10 years, the Chinese market has returned just 0.9% a year, while the U.S. has climbed 12%. What’s driving these disparate results—and should investors expect more of the same?

Primarily at issue has been a set of policies initiated by Xi Jinping’s government in 2020. In November of that year, Chinese authorities halted the planned initial public offering (IPO) of Ant Group at the last minute. Ant is a financial technology company controlled by entrepreneur Jack Ma. By way of background, Ma was also the founder of Alibaba and is probably the country’s best-known business figure.

Why did Beijing squash Ant’s IPO? While there was no official word, most observers believe it was in response to comments Ma had made in the month prior to the planned offering. Ma had criticized China’s banking system, saying it had a “pawn shop mentality,” and also criticized government regulators. In the words of one China analyst, “He apparently crossed the invisible red line for what can be said and done in Xi Jinping’s China.”

Soon after, Ma was forced to give up voting control of Ant Group, and the company was fined nearly $1 billion. The government also punished Ma’s Alibaba with a $2.5 billion fine. Both of these enforcement actions were seen as arbitrary. But perhaps the story’s most disturbing aspect was that Ma then disappeared from view for several months, raising questions about his well-being.

Ma later reappeared, but with a lower profile. According to a colleague, he was “doing very, very well” and had taken up painting. It was an extremely odd turn of events for someone who had at one point been China’s wealthiest person. If this had been an isolated incident, perhaps it could have been explained away, but the government’s actions against Ma were just the beginning.

Beijing broadened its campaign to target other powerful companies. Since then, many more firms—mostly in technology—have been fined or sanctioned and, as a result, seen their stocks fall. Tencent and have seen their shares drop by half.

Despite the negative impact on investment markets, Xi’s government shows no sign of slowing its efforts to weaken powerful companies. In fact, just last week, the planned IPO of online retailer Shein hit the rocks when Chinese regulators announced a “security review.” This was reminiscent of the move Beijing took against Didi Global in 2021. Didi, which runs a ride-hailing app similar to Uber, had just completed an IPO on the New York Stock Exchange when the government opened an investigation. The charges were varied and vague. But in the end, it was forced to delist, punishing both the company and its shareholders.

In addition to the negative effect of these moves on share prices, second-order effects have now started to occur. International investors are showing a growing wariness toward China, as evidenced by last year’s drop off in foreign direct investment (FDI). FDI dropped to $15 billion in 2023, down sharply from $180 billion the year before. Prior to that, FDI in China had been above $150 billion every year for more than a decade.

Because of Beijing’s penchant for punishing its most successful companies, observers are now asking whether Chinese stocks are worth purchasing at any price. Desmond Shum is the author of Red Roulette and knows China well. In a recent online post, he asked, “How should China companies be priced? How much discount should be priced in? Erratic behaviors of CCP [Chinese Communist Party] since Xi and growing geopolitical risks make China uninvestable.”

At the same time that these policies have caused share prices to crater, authorities have taken steps to try to prop up prices. Since the fall, regulators have been providing “window guidance” to institutional investors in China, the effect of which has been to prevent them from selling stocks. But this heavy-handedness has only created new distortions in the market.

As one Shanghai-based investor explained, window guidance “creates delayed selling pressure, but it’s not like you can postpone that forever. Market sentiment will eventually dictate performance.” In other words, this window guidance has created an additional problem: Share prices now sit on an even shakier foundation.

Investors have come to distrust the Chinese government both in what it does and in what it says. Indeed, even basic economic data aren’t viewed as reliable. In 2023, according to Beijing, GDP grew 5.2%. But many view this as an essentially made-up number. Research firm Rhodium Group estimates that growth was below 3%. One well-informed investor I spoke with called the government’s 5.2% “a joke.”

Further challenging its economy, China is now contending with a demographic problem. Decades of efforts to slow its population growth have had unintended consequences. In 2023, fewer babies were born than in 2016, the year China abolished its one-child policy. The fertility rate is now close to 1, far below the 2.1 that’s required for a population to remain level. And unlike the U.S., China receives virtually no benefit from immigration.

This trend is a problem for investors because population growth is a key contributor to economic growth. In simple terms, a growing population provides a greater number of customers for businesses to sell to. And more workers also help drive economic activity. An aging population, on the other hand, slows an economy and places greater burdens on public finances.

Warren Buffett often says that there are no called strikes in investing. This is a baseball term meaning that investors are never compelled to take any particular action. They have the luxury of waiting for another opportunity. Because of all the challenges described here, my advice in recent years has been to simply steer clear of any investment in China. If you want emerging markets exposure, look to a fund that excludes China, such as the innovative Freedom 100 Emerging Markets ETF (symbol: FRDM).

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X (Twitter) @AdamMGrossman and check out his earlier articles.

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