Articles - Your Dreams are China in your hand

 By Alex White, head of ALM Research at Redington

 As this increases, the weight to China in the MSCI EM will increase - if there are no relative stock price moves it will change from 25% to 40%(1). And where the index goes, so do passive investors; and active investors with TE limits, which is most of them. There’s a structural reason to expect increased demand.

 There are also more tactical reasons. China is the world leader at building renewable power plants, producing over three quarters of batteries made today, for example. This means it is well positioned in plenty of industries which are likely to be crucial in the future.

 The valuation metrics, insofar as they can be used, are quite extreme, around 1-1.5 standard deviations from central. For example, P/E ratios are around half those of the S&P500. Value opportunities are never comfortable at the time, but this could be one.

 There is also a materially different structure, as the Chinese market has far more retail investment proportionately than the US or Europe. This means when an active manager makes a trade, the other side is less likely to be another well-resourced professional manager with a risk-management process and bespoke systems, and more likely to be an individual investor with less mitigation against behavioural biases. All else being equal, it should be easier to make money as an active manager in a less institutional market (certainly at Redington, our chosen managers have generated very considerable alpha).

 Finally, there’s a diversification case. These are listed equities, with plenty of liquidity. From first principles, there’s a strong case that if you don’t know the future (and no-one does), then as much as is practical hold a little bit of everything sensible (in a risk-managed way).

 So that’s the bull case. What about the bear case?
 There are tactical bear cases, notably housing. Shanghai median house prices are 49x median income, making it around 3x more expensive than London(2). That could be a consequence of a different culture, particularly around family living; it could also be a bubble.

 However, the big ones are political, and the biggest one is Taiwan.

 China has made very clear that “reunification” is the goal, but so far its approach has been peaceful. How the war in Ukraine develops may well be a determining factor in their deliberations, and it’s not simple; for example:
 • China is a much bigger part of the global economy than Russia, and it would be much harder to impose blanket sanctions on China like those applied to Russia.
 • If the US stops support for Ukraine, that could signal a lack of patience or stomach for an attritional fight, which could incentivise an invasion.
 • If Trump is elected again, his general unpredictability(3) increases the odds of a tail risk event - either via isolationist policy or by a fear of looking weak.

 The bull case is based on technical and financial issues, while the bear case is more around existential tail risk. There is a tail risk, and whatever the chances are, if political uncertainty increases more broadly that probability is likely to be higher than it has been over preceding decades.

 So, what should investors do?
 For some, the technical reasons to expect strong outperformance may be so great they need to hold it; for others, it may be a tail risk headache that doesn’t justify the governance. Many will be somewhere in between. As boring as it may be, general investment principles suggest holding some, just not more than you can afford to lose. That’s rarely a bad approach to take.