China Backpedals on Capitalism

08/11/2021: Emerging market equities have trailed the US and developed markets so far in 2021. The S&P has expanded nearly 20 per cent and developed markets are up over 11 per cent. But emerging market equities are barely positive despite having surged to a nearly 12 per cent start through the beginning of February. The MSCI Emerging Market Index has virtually flat-lined this year, but that belies the extent of diffusion underneath the surface. The Index comprises 20 countries, including Russia, Taiwan, Mexico and China; countries like the Czech Republic and Jordan have advanced more than 20 per cent, while Colombia and Peru have retreated by a similar amount.

Graph 1, Market Update, 08.11.2021

Notwithstanding the diversity of countries, China represents nearly one-third of the index – a share that’s larger than the technology allocation in the S&P 500. That means that an emerging market allocation has been increasingly a bet on China. Yet China has become increasingly engaged in a tug-of-war between capitalism and communism.

Graph 2, Market Update, 08.11.2021

Emerging market equities peaked in mid-February and rolled over to coincide with the assertive moves of Beijing’s heavy hand in Chinese business. The Communist Party, led by President Xi, has targeted public and private companies which they believe have gotten too powerful or profitable at the expense of Chinese employees or customers. The crackdown has wiped out more than $1.2 trillion in market value for many powerful Chinese companies, according to CNN. High profile e-commerce company Alibaba (BABA) was slapped with a record $2.8 billion fine after regulators accused the e-commerce company of behaving like a monopoly. Other firms, including social media and gaming giant Tencent (TCEHY), were hauled in front of authorities investigating alleged anticompetitive behavior as well. The latest research report by Cornerstone Macro counted 52 major regulatory moves by Beijing since last November, with seven actions so far this month alone.

Graph 3, Market Update, 08.11.2021

Meanwhile China’s economy is slowing. Blame the global pandemic, but China’s exports are contracting, according to China Federation of Logistics and Purchasing data. Financial conditions are tightening, despite the PBoC’s recent reduction of the banking systems’ reserve requirement. China’s manufacturing data is growing at a slower pace, due in large part to disruptions at one of the nation’s largest ports caused by the COVID-19 outbreak.

Graph 4, Market Update, 08.11.21

Beijing’s regulatory sweep, combined with China’s growth deceleration, suggests the world can no longer rely on the world’s second-largest economy as a growth engine, a role it has served for the last decade or more. That means demand for commodities, including energy and industrial metals, will likely slow as the country turns inward. Given China’s outsized importance, it could exert some gravitational pull on countries like Vietnam and Malaysia that have historically relied on Chinese demand.

Nonetheless, we are maintaining our emerging market equity allocation, thanks in large part to its relative attractiveness on a valuation basis. We also note that that slowing growth doesn’t suggest an economic contraction. China’s GDP expanded 12.7 per cent over the first half of the year and is on target to achieve 6 per cent growth in 2021; this is hardly a recession. Institutional investors so far appear undaunted by Beijing’s heavy hand: they’ve contributed nearly $3.9 billion into China equities in recent weeks, according to Barron’s. Given China’s outsized influence, we recommend investors take an actively managed approach to the asset class.

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