How to invest in China is the question I am asked the most.
China is facing a lot of headwinds. The economy has slowed dramatically from the post-Covid reopening boost at the turn of last year and geopolitical tensions are everywhere for people to see. Against this backdrop, I see a three-pronged approach to China investments.
- First, focus your China equity investments in areas that are less likely to face headwinds.
- Second, diversify to other parts of Asia.
- And third, consider partial reallocation to equity long-short hedge fund strategies, if possible.
I always find it useful to talk to taxi drivers. They are a great gauge of sentiment when it comes to investing. The first thing I do is tell them what I do for a living – help investors identify risks and opportunities in the markets.
Then I sit back and wait for whatever questions come next. In 1999-2000, it was all about internet stocks. In 2008, it was about property markets. In the summer of 2011, it was gold. These all coincided with major bubbles and peaks being formed.
This year, most of the questions were on two topics, on opposite sides of the ledger. On the positive side were the questions on the ‘Magnificent 7’ (the seven US tech-related growth stocks that drove the rally this year) and AI.
Now I want to talk about China. Here, the prevailing market sentiment is all doom and gloom. It is really difficult to find anybody who is bullish on China. Of course, there are some good reasons to be worried about the economic outlook.
Switch from property?
First, the massive over-investment in the property sector creates a huge overhang for economic activity. This had been a major driver of economic growth over the past 10-20 years, so the decision by authorities to (rightly) tighten controls effectively removes a key source of economic growth.
Meanwhile, it is likely that property prices will need to adjust markedly lower, which will impart a significantly negative wealth effect on consumers.
Second, we know the population is ageing rapidly, which will reduce growth unless there is a sharp (and unlikely) acceleration in productivity growth.
Finally, geopolitical tensions are very elevated. This creates huge uncertainty for companies, both domestic and foreign, when it comes to committing investments into China. We have already seen foreign direct investments (FDI) into China start to dry up, while domestic Chinese companies continue to expand their investments into other markets.
This naturally leads to the question: should we just give up on investing in China? We think this would be the wrong approach. While the economy is facing significant headwinds, it is still expected to outpace growth in the developed world.
Meanwhile, China’s equity market valuations are very cheap and sentiment is extremely negative, which means the hurdle for at least a short-term rally is very low. What the trigger would be for such a reversal in fortunes is unclear, but if it were clear, markets would already have rallied.
Therefore, we suggest a three-pronged approach for those having large investments in China.
- Focus on the China’s equity sectors that are likely to outperform and avoid those that are likely to underperform. In developed markets, this is easier said than done. However, in China it appears to be significantly easier. Our sector allocations have, on average, outperformed the broader equity market benchmark by a significant margin over the past two years.
We currently have a preference for the communication services and consumer discretionary sectors.
- Second, broaden investments to include the rest of Asia. The geopolitical risks undermining sentiment in China are a boon to economies in the rest of the region, with Thailand, Indonesia, Malaysia, Vietnam and even India likely to benefit from the redirection of foreign direct investment and trade flows.
Meanwhile, the global semiconductor restocking cycle is likely to support the performance of Taiwan and Korea stock markets in the months ahead. There are even reasons to be more bullish on the outlook for Japan as the economy appears to be recovering from decades of deflation and the focus is shifting more towards shareholder returns, share buybacks and higher dividends.
- Third, don’t just focus on long-only exposure in China. We see significant dispersion in the performance of different stocks and sectors in China in particular, but also across Asia more broadly.
Therefore, shifting some allocation from China stocks to Asia equity long-short strategies should reduce the volatility of your portfolio and could be beneficial from a return perspective.