Hong Kong brands itself “Asia’s world city”, a label that has been mostly deployed in mockery over the past three years of political suppression and pandemic-induced isolation. Yet the city’s government would like to make the slogan true once again. It had hoped the Global Financial Leaders’ Investment Summit, which welcomed financial bigwigs on November 2nd, would advertise the once semi-autonomous city’s return to the world. Instead, the event turned into another symbol of the headaches facing Western investors in China. Mainland bankers, with whom chief executives would have hobnobbed, could not attend without ten days of quarantine on their return home. American lawmakers urged executives not to go, citing China’s human-rights record.
China’s stockmarket offers another illustration of the forces battering once-optimistic investors. Although it inched up slightly in recent days, on unfounded rumours that China’s “zero covid” policy may soon come to an end, the Hang Seng China Enterprises Index, a basket of Hong Kong-listed Chinese stocks, is down by almost 40% this year. The lack of any change of tone at the Communist Party Congress in mid-October led to the most recent lurch. Warning lights elsewhere are also flashing red. A deteriorating property market threatens to upend China’s economic-growth model. Souring relations with America have led to new trade restrictions, most recently on advanced chips.
Yet for much of the past decade, big investment houses have made rosy predictions about Chinese stocks. Speaking in Hong Kong Colm Kelleher, the chairman of ubs, said that global bankers were all “very pro-China”. Last year analysts at Nomura, a Japanese bank, predicted that the 2020s would be “the decade to double down on Chinese equities”. At around the same time, BlackRock, an investment firm, suggested that allocations to China should be two to three times their current level, of around 4%, in major indices. JPMorgan Chase’s long-term capital-market assumptions, published in mid-2020, projected annual returns to domestic Chinese stocks of 8% over the next 15 years.
Could those firms have foreseen today’s difficulties, or is that just the wisdom of hindsight? The pandemic, and the Chinese government’s reaction to it, was difficult to anticipate. In 2016 Tim Atwill, then at Parametric Portfolio Associates, a provider of direct-indexing services, was a lonely sceptic on the matter of including domestic Chinese stocks in the major emerging-market indices. He argued that the broader industry was “blindly accepting a major allocation to a market that has shown little interest in the rights of foreign investors”. The abolition of presidential term limits in 2018, when Xi Jinping began to entrench himself at the top of Chinese politics, should have been a moment for introspection. The direction of travel was abundantly clear by the time Mr Xi began to crack down on the country’s tech giants in 2020.
However, the reality is that the bulls are rather less bullish than they appear at first glance. Even many funds that in public wax lyrical about Chinese investment opportunities limit themselves to allocations to China of just a few percentage points. Domestic Chinese shares are given an inclusion ratio of 20% by msci, an index provider, in its benchmark stock indices, meaning that their presence is a fifth of what it would be at a full market weighting.
This discrepancy, between ebullience in public and a more measured approach in practice, reflects two realisations. The first is that speaking out against China has unwanted consequences. After JPMorgan issued a report in March saying that China was uninvestible, the bank lost its position as a lead underwriter for a listing in Hong Kong of a Chinese cloud-computing firm.
The second realisation is that investing in China now comes with a serious tail risk attached: that investments could one day go to zero, should Chinese politics go horribly wrong or tensions over Taiwan ratchet up, to the extent that trade and financial links between China and the West are severed entirely. True, China could easily plod along. Yet the risk, even if relatively small, of a nightmare scenario warrants a more modest asset allocation—one that offers exposure to the mainland, but does not have the potential to sink a portfolio if the worst comes to pass. For all the efforts to suggest otherwise in Hong Kong, it is the likelihood of disaster that will have been on everyone’s mind. ■
Read more from Buttonwood, our columnist on financial markets:
The surprising maturity of the crypto-rave crowd (Oct 27th)
Can Britain escape the “moron risk premium”? (Oct 20th)
Credit-default swaps are an unfairly maligned derivative (Oct 13th)
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