MON 21 MAR 2022
Sir Winston Churchill once described Russia as a “riddle wrapped inside a mystery, inside an enigma.” He could also have been referring to China. A key element of our philosophy and process is to have an appreciation of “what we don’t know” especially when it relates to the complexity of geopolitics.
The conflict in Ukraine has clearly increased intricacy for China. As Tom Plate wrote in a recent opinion column in the South China Morning Post, “having to carry the burden of an alliance of some sort with Russia at a time of the latter’s gruesome humanitarian criminality in Ukraine must be hard on the nerves.” He added, “the problem is that any invasion, even by a presumed ally, is a blatant rejection of its axiom of non-interference in the internal affairs of another sovereign state.”
The bottom line is that Beijing’s relations with Moscow plus its core principle of non-interference and no first use of nuclear weapons suggests that China might be in a strong position to negotiate an end to the conflict. Put another way, we do not believe that it is in China’s national interest to support Russia if that led to comparable isolation and sanctions. Punitive sanctions on China would clearly exacerbate global supply chain dislocations and risk a global depression (China is a much larger share of the global economy compared to Russia). The potential fallout from an economic perspective would be catastrophic for the China and the global economy.
What we also know with respect to China is that there is a Chinese Communist Party Congress in the fourth Quarter this year. China’s policymakers care about macro and financial market stability. That is a plausible reason for the March 16th Statement by the State Council to support the economy, real estate and internet sector. The statement was also probably a signal that the regulatory crackdown is near a conclusion or that policymakers will be more cautious when implementing new measures that could impact the economy in the short term.
Our sense is that it also increases the odds of further monetary and fiscal easing to support the economy over the balance of 2022. As we have noted previously, that is already evident in the recent positive inflection in the credit impulse. Of course, policy easing in China is complicated by rate hikes and quantitative tightening in the United States.
The powerful impulsive rally last week in Chinese equities following the announcement of support from the State Council, needs to be viewed in the context of the -14% capitulation earlier in the week and the large drawdown over the past 12 months. The rapid and emotional (waterfall) price action, combined with valuations near trough levels and foreign investor capitulation was the key reason why we added exposure last Tuesday (chart 1).
While we are sympathetic to deep investor scepticism on Chinese and China-sensitive equities, valuation has compressed near trough levels at a time when credit, liquidity and policy support has started to turn up. Global recession risk has increased over the past few weeks (as signalled by the yield curve) and concerns on regulation in China (and ADR risk) has not completely dissipated. The surge in commodity prices is also challenging for China as a large net importer. However, our sense is that policymakers in China will be motivated to promote stability (rather than chaos) and support the economy and financial markets for the remainder of this year ahead of the CCP Congress in November.
Nonetheless, it is important to appreciate what you don’t know. Therefore, from a risk management perspective we remain 11% underweight Chinese equities in a regional context and very, very liquid. On the positive side, the current episode is probably an opportunity to increase (not decrease) exposure to China and the region which trades at a 64% discount to US equities. However, we would still have a preference for “quality” within equities (high free cash flow, low balance sheet leverage and sustainable growth) given amplified macro risk on the cycle and US policy/liquidity withdrawal.
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