Volatility Strikes China

Editors’ note: This article touches on political matters, which MarketMinder takes no sides on, favoring no party or politician anywhere. We assess political developments solely for their potential market impact—or lack thereof.

Volatility has struck Chinese stocks,^[i] leading many globally to question: Is this the start of something bigger and longer-lasting? Most coverage associates China’s market volatility with familiar concerns in the developed world: prospects for monetary policy tightening, slower economic growth and a regulatory crackdown on Tech and Tech-like sectors crippling recent high-fliers. We don’t disagree that some Chinese companies are facing some regulatory uncertainty on both sides of the Pacific, but the key consideration is how much negative surprise power remains from here. In our experience, markets are pretty efficient at dealing with things like this, and we think the surprise power from here is more likely to be positive than negative. 

In US dollars, the MSCI China Index—a broad gauge of Chinese shares listed in the mainland, Hong Kong and America—is in a deep correction, off -16.7% from its February 17 high.^[ii] Now, it may be worth noting the index isn’t entirely accessible for global investors, as 20% of its market cap represents A shares, which are restricted mostly to Chinese mainland investors. But its largest shares by market cap are ADRs—Chinese companies that list and trade in the US. These have encountered trouble thus far this year, tied largely to escalating delisting talk.

It first ramped up last December when former President Donald Trump signed the Holding Foreign Companies Accountable (HFCA) Act. The new law requires firms to verify they aren’t owned or controlled by a foreign government and to employ an auditor subject to the US Public Company Accounting Oversight Board’s inspection—or face delisting from American exchanges. This is a particular problem for Chinese companies because national security laws seemingly prevent Chinese auditors from releasing information about their processes to US regulators. After some initial hubbub, without much incident, talk about this faded. Until last week: The SEC began implementing the HFCA Act under the new Biden administration. More now say delisting is likely, if not inevitable.

We aren’t dismissing these obstacles, and Chinese stocks also have some local regulatory headwinds to contend with. But a key question to ask now is how much negative surprise power remains from here. As we wrote in early December when Congress approved the HFCA Act unanimously, the delisting threat isn’t new, and it is important to consider what it does and doesn’t mean. For one, the HFCA Act gives companies a three-year grace period to comply before possible delisting—this issue isn’t immediate. Not only is three years a long time, but many potentially affected Chinese companies have sought secondary listings in Hong Kong. A US ban probably wouldn’t impact their operations or access to global investors all that much longer term. After all, many, many global investors have been seeking far greater access to domestic Chinese firms for years, and they seem quite willing to buy on non-American exchanges.

We already got a preview of this in January. After Trump issued an executive order banning trades in companies linked to China’s military, the NYSE announced New Year’s Eve it would delist three Chinese companies. But on January 4, the NYSE reversed its decision, only to reinstate it again after a call from then-Treasury Secretary Steven Mnuchin the next day. Amid general bewilderment and lack of clarity from decision makers, the ban took effect January 11. The companies’ shares are now trading in Hong Kong. Owners of the old ADRs have until November to sell them or convert them to Hong Kong-listed shares.

Markets are well aware of the regulatory endgame. Besides, forcing share trading in one liquid venue over another doesn’t have much negative effect anyway. While the firms now delisted in the US saw their Hong Kong shares dip ahead of their ban, they rallied afterward. Two of the three are nicely up since the NYSE’s initial announcement—the other is flat. Similarly, two are outperforming MSCI China and the third is in line year to date. The companies’ diverging performance implies: 1) delisting isn’t necessarily damaging, and 2) it isn’t the only thing driving these stocks. Once it is priced, markets move on.

On the Chinese side, reports swirled last week the People’s Bank of China (PBoC) will step up efforts to oversee and regulate China’s internet platforms, including all digital commerce and payments. There are risks here worth monitoring as they develop, but heavy-handed intervention from Beijing is nothing new for Chinese stocks, particularly large Tech and Tech-like companies. We think it is part of the long-term backdrop—something many Chinese firms are fairly accustomed to, not a new, fundamental change.

Our opinion of the latest financial regulatory proposals making the rounds is largely the same. In addition to higher capital requirements, regulators are considering a government-backed joint venture with China’s biggest internet firms engaging in financial services. This would expedite the government’s data collection efforts for greater control over users’ activities. But exerting an abundance of caution likely restricts credit, especially to riskier private borrowers and economically sensitive value firms. This isn’t great news, but it isn’t surprising, either. Regulators have been moving in this direction for years, in the name of curbing excess and increasing financial stability. This might result in slower overall GDP growth, but it is mostly a headwind for heavy industry and Chinese value stocks.

We think China’s growth stocks are best equipped to weather an economic slowdown, and US-listed Tech and Tech-like Chinese companies are quite growthy. As policymakers deemphasize low-quality, short-term growth to focus on stable, long-term expansion, China’s Tech-like firms don’t seem as exposed as more cyclical companies. They don’t depend much on fiscal stimulus or overall economic acceleration. China’s development is transitioning ever more toward consumer spending and services as a percentage of its economy. This is increasingly conducted over mobile and online platforms, just like much of the rest of the world. The underlying shift should only increase demand for the gaming, social media, digital commerce and cloud services that Tech and Tech-like companies are well positioned to deliver. There is extra regulatory scrutiny because of these firms’ strong business models. But we don’t think their growth will automatically wither from the attention. It could just as likely entrench—and enhance—their standing by preventing competitors from entering these fields.

In our view, it is important to look forward, like markets do. While policy uncertainty appears to have dampened sentiment recently, we don’t see it as fundamentally altering China’s long-term growth trajectory or presenting material negative surprise on the regulatory front. This sets the stage for upside surprise. Now, that doesn’t rule out further volatility, as corrections’ beginning and endpoints both defy prediction. But in the longer term, reality seems poised to exceed expectations brought low by the supposed threat regulations pose.

Context is always key for global investors, especially when the road gets rocky in places. That is when it is most important to get your bearings, take stock and remember the price for reaping longer-term returns is enduring short-term volatility.