Between March 2020 and late February 2021, the broad CSI 300 Index delivered about 30 percentage points more performance than the S&P 500. During the past six months, positions reversed: the CSI is now about 12 percentage points behind the S&P taking into account the appreciation of the renminbi or Chinese yuan (CNY).
Flagship Chinese tech stocks traded in the US, most of which are not included in the CSI Index, are down much more. There’s a vigorous debate over whether Chinese stocks are investible at all, with Bridgewater’s Ray Dalio most-quoted on the pro side. Softbank’s Masayoshi Son says that he will remain on the sidelines until China provides more clarity about regulation.
I don’t think it’s the right time to bail out of Chinese stocks, for several reasons. The S&P 500 is trading at roughly double the valuation of the CSI 300, around the highest in history.
Why are US stocks so expensive?
First, China has maintained a much tighter monetary policy than the United States. Consumer price inflation is running at a 1% year-on-year rate of increase in China versus 5.4% in the US. The Chinese are more sensitive to inflation than Americans, because a great many have long-term jobs with state-owned enterprises with wages that adjust slowly.
The US engaged in massive stimulus in response to the Covid-19 pandemic, pumping US$5 trillion of demand into the economy and pushing real interest rates to historic lows. China meanwhile continued to reduce leverage in government finances, especially at the local government level where a great deal of debt lurks off the balance sheet in local government financing vehicles.
Most importantly, China kept real interest rates firmly in positive territory (see chart), while US interest rates are deeply negative. If you have to pay the US government to hold your money for you, stocks look a lot more attractive than bonds.
This sort of fiscal and monetary expansion can’t go on forever. It’s already produced the worst inflation since the Jimmy Carter era 40 years ago. US stocks are vulnerable to a whopping correction if inflation continues in the 5% range. China has taken the pain up front by keeping monetary policy restrictive.
Aside from monetary policy, the central concern of investors is brusque and often ham-handed changes in China’s regulatory regime. The regulatory crackdown is not Xi Jinping’s personal rampage against capitalists, as George Soros appears to believe, but a rational – if often painful – policy with objectives that for the most part are reasonable and will have long-term economic benefits.
The regulatory shift began last November with the suspension of Ant Financial’s world-beating initial public offering. It may have had a political motivation. Nonetheless, Ant was highly levered, and the Chinese regulators prudently required the firm to turn itself into a bank holding company subject to the same capital ratios as the rest of the financial system.
Chinese regulators have also imposed substantial fines and other penalties on China’s online retailing giants and have campaigned against excessive participation in video games. They also shut down the country’s private tutoring sector and gutted its earlier market capitalization of nearly $100 billion.
Government intervention was sudden and heavy-handed, but entirely rational. Jean Twenge, a University of California psychologist who has become a bestselling critic of the internet companies, argues that social media and smartphones have destroyed a generation.
Although China pulled the rug out from under the private tutoring companies, it also announced that the government would hire 70,000 tutors – that is, most of the staff the private companies will let go. The ferocious competition for university slots in China allocates the best teaching talent to private firms paid by affluent Chinese. That appears unfair to the aspirational poor, and the government wants to level the playing field.
The aspect of China’s new regulatory regime that is most concerning is national security, as I wrote late last month in Asia Times (“When cyber wars become shooting wars”). China made headlines when it suspended downloads of the ride-hailing app Didi immediately after its IPO, citing network security concerns.
But immediately afterward it suspended downloads of the ubiquitous WeChat application, without which life in China is unimaginable. Again, the issue was network security. That is remarkable, considering how tightly WeChat controls new registrations. You cannot simply register for the app; an existing user with a verified account must vouch for you. WeChat uses facial recognition and voice prints for login.
Clearly the Chinese are locking down their networks for a prospective cyberwar. In addition, the Chinese-language media are full of long-form stories claiming that the Central Intelligence Agency uses American venture capital groups to conduct espionage.
An August 13 article by Hu Haina in the “Observer” website, a hawkish outlet close to the State Council, claims that the organization Business Executives for National Security and the CIA-sponsored venture capital fund In-Q-Tel used nefarious methods to gain control of the French SIM card maker Gemplus “to monitor billions of users worldwide.”
In any case, China will discourage its tech companies from raising funds in the US, and forbid them to store data in the American cloud. The prospective tech unicorns will have to go to Shanghai or Shenzhen for capital. That depresses valuations for the time being. There is plenty of capital in China, though.
Antagonism between the United States and China remains the biggest question mark over China’s stock market. Regulatory slap-downs against tech companies like Didi seemed to come out of nowhere, and appear motivated by Chinese national security concerns. A broad portfolio of Chinese equities seems a sounder investment than prospective tech unicorns.
China’s medium-term growth prospects are better than those in developed markets. It is less dependent on short-term fiscal stimulus and less threatened by inflation, so it has less risk of a shift in monetary regime.
It has problems with Covid-19, but less than any of the major Western economies. Regulatory risk is significant, but its impact is likely to attenuate over time. Investors can buy long-term earnings in China’s stock market at half the price they pay in the US.
All these are reasons to stick with Chinese stocks despite the recent reverses.