Investors are in the early stages of repricing a range of China-related risks, as they seek direct and indirect ways to tap into the broader Asian growth story in an increasingly complex geopolitical climate, according to renowned geopolitics expert Stephen Kotkin.
His comments to Investment Magazine’s Equities Summit, fell within a wider discussion about the need for a bespoke approach to emerging markets, where experts argued the poor recent performance of the MSCI Emerging Markets index hides lucrative opportunities that can only be accessed by careful active selection.
Kotkin, the John P. Birkelund ’52 professor in history and international affairs at Princeton University, told the summit a range of China-related risks had been underpriced for a long time, and investors were now in the process of repricing.
“We don’t yet know where this is going,” Kotkin said. “And anybody who tells you they know for sure where it’s going is making it up.”
Categories of Risk
Kotkin put China-related risk into three categories: ordinary risk, extraordinary risk and un-priceable risk.
Ordinary risk involves China’s demographic challenge with its ageing population, along with the difficult transition it needs to undergo from an investment-driven growth model to a consumer-driven growth model, and the so-called middle-income trap where countries historically struggle to transition from middle- to high-income.
In this ordinary risk category, China’s demographic challenge with its ageing population is significant and gets a lot of airplay, but this is not its greatest problem, Kotkin said. If China were able to achieve the same workforce participation of the elderly as Japan, there would be almost 40 million additional able-bodied retirees available to the workforce.
The second two challenges are greater, he said, combining to make a “double transition” China needs to undergo, both of which are historically difficult and rare.
With 40 to 50 per cent of China’s GDP growth coming from investment, China’s investment-led growth model is leading it down a “cul-de-sac” as demonstrated by the recent performance of its property market among other indicators.
China needs to transition to a consumer-led model of growth, and “that transition will not be easy and it has not really begun yet,” Kotkin said.
The middle income trap
On the middle income trap, since 1960 out of 108 middle income countries to emerge, only 13–such as South Korea and Israel–have transitioned successfully to high-income countries. This was the largest risk to watch in the ordinary risk category, Kotkin said.
Despite China’s large population of STEM graduates in absolute terms, in relative terms China has the lowest level of educational attainment of any middle income country–“lower than anyone has ever had who made the transition from middle income to high income,” Kotkin said.
While slowing growth doesn’t mean no growth, China’s growth rate will be significantly different from what investors are used to as it grapples with these challenges, Kotkin said.
In the “extraordinary risk” category, Kotkin said Communist Party rule, China’s opaque political system and its ideology have the potential to slow or even completely derail growth.
Mixed up in anti-corruption and anti-inequality campaigns are the Chinese government’s attacks on the private sector, Kotkin said, as the sector’s growing power threatens the Communist Party’s monopoly to rule.
China’s ESG priorities are also in this category, Kotkin said, as China’s consumption of coal, treatment of human rights and government opacity increasingly clash with the expectations of fund members.
“There are opportunities, enormous opportunities, but money managers have to explain to clients how they are navigating ESG in China,” Kotkin said.
Lastly, in the “un-priceable risk” category was the potential for a US-China clash beginning over control of Taiwan, which could drag in Japan, Australia and other allies and partners of the United States.
“The likelihood of this has not gone up in my estimation recently, but of course, I thought the likelihood was much higher than people understood all these past years,” Kotkin said. “For 20 years I’ve been talking about un-priceable risk and the problem of Taiwan as the trigger for a vast destruction of wealth globally.”
In dealing with these risks, some investors will seek to directly invest in China while others will look for indirect investments in China that cannot be “confiscated or destroyed at the party’s whim,” or, alternatively, other countries also undergoing fast growth in the region.
Specifically on the issue of property, Kotkin said “bursting the property bubble is necessary but painful,” and while this isn’t a threat to the financial system, and therefore is not China’s so-called “Lehman moment,” it is a significant risk to the middle class which has a lot of wealth invested in property.
Pricing political risk into equities
Directly following the discussion with Kotkin, a group of experts discussed the risks and opportunities in Chinese equities markets.
Kevin Yeoh, equity research analyst at MFS agreed with Kotkin that applying either a demographic or ESG lens to China does indeed throw up big issues. China is the world’s largest carbon emitter, and in the area of governance there is significant “key person risk”.
“If China was a stock, we would be asking who the potential future CEOs are, and what the board process is for selecting that person, but we don’t really have that clarity here,” Yeoh said.
Forecasting China’s medium and longer term trajectory is getting harder because it means assuming China’s current trajectory will continue. And while regulatory risk is the bane of investors, political risk is even worse, Yeoh said.
“As investors we are good at building models and forecasting earnings, but we are not good at pricing political risk, and the issue with political risk is it can kill your terminal growth rate,” Yeoh said.
Both micro and macro risk analysis is paramount, he said, and investors needed to be “hyper cautious and hyper imaginative.”
While investors had traditionally looked at companies tied to the China growth story but not necessarily beholden to Beijing, investing indirectly in China came with its own complications, he said.
“Look at what happened in sportswear, footwear a few months ago with Xinjiang issues affecting Nike’s stock price,” Yeoh said. “So increasingly a lot of these global brands which historically were a way to play China exposure…they’re becoming intertwined with all of these geopolitical currents, and so navigating that riptide of geopolitics with ESG is becoming a lot more complex.”
Wenli Zheng, portfolio manager at T. Rowe Price who grew up in China, said while the specifics and timing of policies from Beijing can be difficult to predict, they are consistent in the direction they are taking.
“Let’s take the recent policy on property, education and healthcare for example,” Zheng said. “Those are not entirely new. Many of those policies have been introduced 5 to 6 years ago. And the government agenda is also very well forecasted, which is to lower the cost of living, to provide equal access to education as well as to build a more equitable society.”
He said the Chinese government’s moves against the “walled gardens of the tech giants” are similar to struggles other governments face due to the rising power of technology companies, and third parties were needed to step in to balance the power and maintain an open ecosystem for all stakeholders.
While China faced demographic headwinds, its “engineering dividend has just started” with 30 to 40 per cent of the total population set to have college degrees in the course of two to three decades. China was also a major exporter of renewable energy, and had made big strides in the electric vehicle sector, he said.
Matthew Kempton, deputy chief investment officer and director, equities, Funds SA, said investors looking at China cannot simply overlay the same approach they take to investigating potential managers in Australia, the United States or Europe. Managers must have mandarin speakers and good access which they can demonstrate, he said, as well as clear positions on government policy and how they will navigate that.
“Some of the changes that we’ve seen recently, those decisions that have been made by the Communist Party and the impact they’ve had on some of our managers…in some instances we’ve seen managers seemingly caught by surprise.”
Look beyond the benchmark
Highlighting the challenges of exposure to emerging markets, experts argued in a discussion that followed that investor complaints about the poor recent performance of emerging markets began with a poorly constructed benchmark, and a careful active approach is needed.
Daniel J. Graña, portfolio manager, emerging market equity at Janus Henderson, said the MSCI Emerging Markets index contained more than 25 per cent state owned enterprises, and its absence of a range of key technology companies “over represents the past and under represents the future.”
“When you look at the index, we are a diverse set of nations, more than 27 countries, many different markets, many different stages of economic growth,” Graña said. “Not surprisingly, when you don’t have a super strong global tailwind, there will be differences [in economic performance].”
Sara Moreno, emerging markets equity portfolio manager at Jennison Associates, argued even Alibaba and Tencent, which form a large component of the index, are more mature companies. Investors needed to look beyond the index to access the paradigm shift in emerging markets–away from things like exports and commodities cycles to secular growth opportunities in innovative and disruptive technologies.
“These new innovations and technologies are driving structural changes and productivity gains that many policy reforms have failed to bring across emerging markets,” Moreno said. “So what this paradigm shift implies is that there is a whole new opportunity set across emerging market equities that investors with an active, bottom-up approach can unearth.”