China Tells the World You're Not the Boss of Me
As we wrote in November 2020 in Kissing the Ring, or, The First Rule of Power, we at goodstead are skeptical of the case for investing in Chinese companies. The Chinese Communist Party doesn't believe in the rule of law or individual property rights, much less rights of any kind at all. It does believe, however, in maintaining its grip on power in China, and in doing whatever it takes to accomplish this singular goal.
Allow us here to forestall the common objection that goodstead is Sinophobic or worse. We have the utmost respect for the Chinese people and culture, both of which have made invaluable contributions to world history and art. We are especially enamored of the poetry and painting of the Tang dynasty period, among others too numerous to mention here. It is necessary, however, to separate legitimate criticism of the ruling regime from criticism of the Chinese people in general, especially as it relates to the road ahead.
As we wrote in November, the Chinese Government saw fit to rein in one of its highest flying technology companies, Ant Group, and its dangerously impertinent founder and former wealthiest citizen, Jack Ma. The pretense offered then was regulatory action for the purposes of financial stability. Ant's IPO, the largest in history, was shelved and new regulations were promulgated to diminish its market power and growth prospects.
At the time, several well-known boosters of Chinese equities were making the rounds in the financial media talking their book. One of the most prominent of these questioned why global portfolios only hold 3% of their portfolio value in Chinese stocks and bonds rather than the 15% suggested by their share of global economic activity. We at goodstead proffered that perhaps the reason for this country underweighting is because investors think there's an 80% chance of expropriation by government authorities.
Normally things happen slowly in financial markets, so even we were caught off guard by the speed with which the Chinese government exerted control of its "capitalist" economy. Earlier in 2021, record amounts of money flowed into Chinese equities, and the MSCI China Index, a broad-based index of Chinese equities, registered record highs. The chart below shows China's equity returns in comparison to other emerging markets, as well as the all-world index of equities.
The earlier Ant Group intervention was slightly troubling for global equity investors, but it should have been taken as a sign of things to come. The government mandated that all education technology (essentially online tutoring) companies could no longer do business. Purportedly, the purpose of the regulatory action was to level the playing field between those who have the resources to afford private tutoring, and those who do not. The $100 B sector was immediately decimated, losing almost all of its value. The government would also go on to flex its regulatory muscles with an order to remove all of Didi Chuxing’s, a mobility service, apps from technology platforms countrywide citing data privacy concerns. Similarly, Meituan, a food delivery service, became the target of labor regulators which demanded that the company ensure that all of its delivery workers earn the minimum wage.
Regulatory actions have targeted data, human capital, real estate and financial companies. The thing that all of these have in common is that they are all factors of production, and are therefore the rightful province of the power of the state. The Chinese Communist Party is merely doing what they have always told us they will do.
As a result of these actions, the Chinese equity market has surrendered trillions of dollars in value. The Securities Exchange Commission, the US stocks regulator, had earlier required that US-listed Chinese corporations submit their accounts to US accounting standards. The Chinese authorities likewise indicated that they would place a hold on any foreign listings for Chinese companies due to data security concerns. All these signs point in the same direction, that Chinese equity markets are not ready for prime time. Our position in November 2020 remains our position now: investors who place their money in Chinese shares should be prepared to lose substantially all of their investment, and are generally unfit for the long-term investor.
When we talk about the third primary factor which governs portfolio return, we call it regime stability. Investors in developed, western markets tend to focus only on growth and inflation, the two other primary factors, and the only ones that really repay attention in law-based societies. In emerging and frontier markets, however, time and again regime stability proves that it is the most important factor to consider. Investors will do well to remember that.