A lot has happened in a very short time in terms of China’s regulatory actions, and it has appropriately created huge uncertainty and raised many questions among investors. We see China’s acceleration of regulatory steps or reforms as its attempt to de-risk its economy and to get it on a more sustainable growth path. The risks to investing in China have increased, but at this juncture, we still think our overall allocation to China is appropriate.

The Motivations Behind China’s Actions

Since the 2008 financial crisis, China has invested heavily in infrastructure, including property. We have worried about excesses related to these investments going back 10 years. In fact, for quite some time our current base-case scenario has used (and still does) relatively depressed earnings because of risks related to China. In the past several years China has taken regulatory actions or reforms designed to:

• Reducing systemic risks related to their shadow banking system and the property sector

• Fighting pollution

• Fighting corruption, and this includes corporate governance

• Reducing inequality

• Revamping regulations that are more in sync for an increasingly digital economy that China is fast becoming

Broadly a lot of what has been happening over the past year falls in one or more of these buckets. For example, preventing the Ant Financial IPO (a proposed spinoff from Alibaba) in our view was at least in part about reducing the systemic risk it posed to the financial system. The actions against after-school tutoring fall more in the reducing inequality bucket.

The platform companies are facing profit headwinds due to anti-monopoly regulations, somewhat similar to what you’d see from the anti-trust regulations in much of the developed world. And in China, there is also an additional drag from companies being asked to contribute toward reducing social inequality, which we think will be part of the cost of doing business in China. Thus far it does not seem to have a material impact on these platform companies’ future profitability after factoring in the huge market opportunity available to them in China and potential growth.

Turning to the property sector, deleveraging there has been going on for the past several years as part of reducing systemic risks. But it has picked up steam in part due to the social inequality challenge that rising property prices, especially in large cities, poses. The aging demographics adds to the need for China to act relatively quickly. So you have seen China come up with the “three red lines” regulations last year to slow down excessive property building and speculation in home prices. We went into some detail in our last investment commentary on this and reiterate our likely scenario at this point is that this deleveraging is manageable—it will likely lead to slower economic growth and we have seen estimates come down already, and China’s stock market has massively underperformed.

While a lot has been priced in, we’d say the property-sector and related deleveraging risk remains the biggest unknown and worry for us, and it on its own could lead us to reduce our allocation to emerging-market (EM) stocks. It is one risk that remains a question mark as we weigh the positives and negatives. We see an incongruity between meeting social and economic objectives: the need to reduce inequality in a sector that is also a large part of the economy, much larger than the after-school tutoring. Having said that, because this sector is so important, we think the likely scenario is that of a managed deleveraging. The unknown is whether China will succeed.

At an even broader level, we are very mindful that China has a different political ideology than the United States and other western countries and that this ultimately poses risks to corporate profits. Despite this ideology, China has shown strong progress on many fronts over the decades. We think China appreciates the innovation-related benefits that a relatively free market economy generates, but they are also managing it in a way that balances their social objectives.

Investing in EM Stocks and China 

Strategic 

The first and most important reason why we have a strategic allocation to EM ex China and China is diversification. Now the broad EM index weighting has shifted more toward China and the rest of Asia, we think appropriately. At this point, we do not believe we need to treat China and EM x China separately. In the future, as China’s market becomes more deep and developed and there are more investment alternatives—active and passive—to choose from, we may treat them separately.

In our equity model, our strategic allocation to EM stocks is 12%. Of this, China, since it’s the main topic, comes out to be around 4%. Our tactical overweight takes EM stocks to 14% of which China is between 5% to 6%. In comparison, our strategic allocation to US stocks is 60%, and we are almost fully allocated there (excluding funding for managed futures). In absolute and relative terms, given the risks and opportunities we see in both countries longer term, adjusting for quality, we think this is an appropriate level of risk-taking in the context of an overall portfolio that includes stocks, bonds, and alternative investments.

The rest of the equity allocation is to developed international markets. For context, if you were to look on a normalized basis at ACWI index weightings, a good proxy of what the market currently thinks is the global equity opportunity set, our portfolios may have one to two percentage points more in China. In terms of sizing our exposure, that’s how we are thinking about it. Strategically we are roughly neutral to US stocks, which we consider the highest-quality asset class among equities, even though we’d say valuation risk, especially rising-rate risk, is historically higher today in the United States than elsewhere.

Effectively, we believe over the next 10-plus years versus the ACWI index, we want a bit more exposure to Asia ex Japan relative to Europe and Japan, where we see growth challenges longer term.

Further, we continue to believe markets move in long cycles—the past decade has been favorable for US stocks but may not be so looking out next 10 years.

When thinking of overall equity allocation, we weigh both the risks and opportunities as you’d expect. We want to have enough allocation to an improving area such as EM stocks. We can highlight a few of the improvements we see:

• The sector mix is becoming less cyclical, higher in quality, and better growth (such as technology in Asia).

• Increasing digitalization and tech trends are promoting higher productivity benefits across EMs.

• China is an important piece—it has been implementing regulatory reforms the past several years as part of de-risking its economy, which while leading to much slower growth than we have seen in the past should yield more sustainable growth. This could be a good environment for stocks, counterintuitively. It is aiming to have a greater share of its economy driven by higher-value-added industries, not just cheap low-margin manufacturing. This also poses a risk for developed-market profits. Lastly, it is deepening and opening access to its capital markets rapidly, in part because it will help diversify household wealth: currently a relatively large amount is tied up in the property sector.

Tactical

Anecdotally, we see a lot of global pent-up demand for goods and services and for capital investments related to green tech and renewables and general industrial upgrades—all this historically has been positive for the EM profit cycle:

This is happening when there remains in place significant fiscal and monetary stimulus in the system after the pandemic, which we think should be a relative positive for nominal growth. We have seen data that suggests the problem in good part for the last decade for EM economies has not been labor productivity—that remains superior relative to DM markets. But a relatively poor nominal growth and capex environment has plagued EMs since the 2008 financial crisis. Given their relatively high beta to global growth, this is not surprising.

After almost a decade of earnings stagnation, we think EM earnings are poised to recover strongly. This year, earnings have risen more than 40%, mostly driven by EM ex China. Along with downside risks to the US dollar we see (it being a countercyclical currency and given the significant fiscal and trade imbalances for the United States), which historically has been supportive for EM assets, we think odds remain very good EM stocks will generate strong absolute and relative positive returns in the medium term.

We think EM stocks should easily beat bonds in the short to medium term unless we are headed for a global downturn or recession or if, for example, risks related to China property deleveraging turn out to be more material than we currently think are likely or if China pushes its social-inequality related drive to envelop a broad swathe of the economy and in a much more material fashion than we think is likely.

What We’re Watching & Assessing

Risks to investing in China have clearly risen in our minds, starting from their decimation of the after-school tutoring industry, anti-monopoly regulatory push, and common prosperity–related drive that may pressure profits. Before these started to gain intensity, we were considering raising our earnings estimates, in part due to the improvement in terms of the sector and regional mix we were seeing in EMs. Also, we thought the commodity cycle could turn out to be quite positive for EMs, after a decade of underinvestment and poor performance. It is estimated that green capex–related investment alone might mirror that of China’s commodity-related investment in the 2000s. And China is a much larger economy so even its relatively lower growth carries a lot of impact on demand and supply. So even with all those drivers, we have decided to not add to our earnings expectations (as we noted earlier, we believe our current earnings estimates are on the conservative side on account of China-related risks). We think at this point this appropriately accounts for the increased risk and uncertainty with respect to China. Meanwhile, valuations have become more attractive for EM stocks.

So, from here and now, keeping in perspective our overall weighting to China in both absolute and relative terms, the strategic and tactical opportunity we see, and weighing the risks, and considering how we are funding our allocation and the hurdles EM stocks have to jump, we feel our current allocation to EM stocks, including China, is appropriate.

Having said that, there are two key risks we are watching closely:

•  That the common prosperity push takes a much larger bite out of overall profits than we expect. Our active discussions with managers will be one of the key inputs we will be factoring in.

• The property-sector related deleveraging is disruptive and more detrimental to China’s economic growth and household sentiment than we expect. We acknowledge this risk falls largely in the unknowable category, but we will continue to weigh the evidence as it comes.

If we believe any of these risks are panning out worse than we expect or we become uncomfortable taking them, then internally we have discussed unwinding our overweight. So we are keeping an open mind and certainly will not be anchoring to any view.

Our shorter- to medium-term expectation is that China will stimulate and stabilize its economy if needed, and with improving vaccination rates and better nominal growth prospects, we should expect better relative earnings performance from EM stocks and lower risk premiums in EMs.

TYME Advisors subscribes to AdvisorIntelligence, a leading research service for investment professionals that is published by Litman Gregory Asset Management, an independent, fee-only wealth management firm based in the San Francisco Bay Area. AdvisorIntelligence provides our firm with asset class research, manager due diligence, and risk-managed portfolio construction guidance with a 27-year proven track record. Utilizing the resources of Litman Gregory as an outsourced investment strategist and research arm provides significant benefits to our clients, and is a complement to our own work. It allows us to cover more investment opportunities in greater depth than we could on our own, and helps us make decisions on how to allocate your assets to achieve your long-term goals.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.