For once, the opinion polls were on the money. In Taiwan’s election, the Democratic Progressive Party candidate Lai Ching-te won the presidency with just over 40% of the vote, but the DPP lost its parliamentary majority.
Of course, the reason the world was watching had little to do with Taiwan per se and everything to do with China. Taiwan is a key reason – although certainly not the only reason – why the majority of international investors today perceive China to be ‘uninvestible’.
This perception is a marked turnaround from a year ago, when most investors – myself included – thought China’s post-Covid reopening would lead to a bounce similar to those seen in the US, the UK, Europe, Canada, Australia and elsewhere. Except the bounce might be even more potent, since China had been locked down for longer. A year on, we now know this was wishful thinking.
One reason is that China’s labour market is very different from Western labour markets. In the West, when governments paid workers to stay at home, a significant number found they enjoyed not having to clock-on every morning. And when time came to go back to work, a minority never did. This led to a shortage of workers, which pushed up wages. And much of this increase in wages was quickly spent further boosting demand.
In China, the situation was the polar opposite. When cities, offices and factories dropped their Covid constraints, migrant workers who had had little choice but to return to the countryside during lockdown rushed back to the cities, depressing wages. The combination of depressed wages with the continued real estate consolidation soon saw growth fade – and disappointed equity investors made for the door.
And as investors made for the door, the mantra became that China had become uninvestable for four main reasons:
Taiwan risk: When western investors were suddenly unable to pull their money out of Russia, selling China became a necessity – if only to protect careers. If China were ever to invade Taiwan, a freeze on assets in China could be career-ending. That the medium-term probability of an invasion was minimal didn’t matter. The mere existence of the chance meant that for many investors, China was suddenly a risk too far.
Deteriorating US-China relations: Beyond Taiwan, the continued deterioration of the broader US-China relationship has been another sword of Damocles over the heads of China investors.
Policy unpredictability: The crackdown on property developers, the zeroing of education stocks and the take-down of Alibaba following Jack Ma’s combative 2020 speech all reinforced the idea that China’s government could crush a business because of something the CEO said or because it no longer favoured a particular sector.
For many, this made the potential rewards no longer worth the risk. Investors can live with losses on individual names of -5%, -10% or even -25%. But losses of -100% overnight (which is pretty much what education stock owners took) are potentially career-destroying.
The belief that China was following Japan’s deflationary-bust path: With falling real estate prices, adverse demographics and unfolding deflation, the fear was that China could turn out to be a serial capital destroyer, just as Japan had been for almost the last 30 years.
Foreign capital duly flowed out of China throughout 2023, with a crescendo of selling at the end of the year – December saw the third-biggest monthly outflows ever, behind the outbreak of Covid and the August 2015 renminbi devaluation.
As a result, Hong Kong’s Hang Seng index is now down -30% in price terms over the last 10 years. Except for investors who bought in the depths of the 2008 meltdown, or after the panic selling triggered by the 2022 Communist Party congress, the chances are that anyone who bought the Hang Seng after 2006 is down on their investment.
With such ugly returns, foreign investors who have convinced themselves that China is uninvestible are highly unlikely to return in the near future.
Nevertheless, at the margin, news on China’s investibility may have been getting better.
Taiwan risk: Despite the election result, no invasion seems imminent. It is doubtful whether China’s People’s Liberation Army could have pulled off an invasion anyway.
But in the last few weeks, the Communist Party has been cleaning house with a massive anticorruption probe in the senior ranks of the PLA. Yes, Joseph Stalin did purge the upper echelons of the Red Army before invading Finland in 1939, but that really didn’t work out well for him, and it seems unlikely that Xi Jinping would want to risk repeating the mistake.
Deteriorating US-China relations: Like a divorced couple tired of fighting, both parties seem keen on maintaining the relative peace achieved at November’s APEC summit. The Chinese and US communiqués following Taiwan’s election both appear to point in this direction. For now, both superpowers seem content to let sleeping dogs lie.
Policy unpredictability: In December, investors were treated to another taste of this bitter brew. At noon on the Friday before Christmas, when most international investors were heading out for Christmas lunches or getting ready to board planes to take off on holiday, China proposed restrictive new rules for video game companies.
With next to no liquidity in markets, gaming-related stocks including Tencent, NetEase and Bilibili shed a quick -10% to -25%. For investors in Chinese equities who had spent much of the previous four years channelling Kevin Bacon in Animal House, alternately pleading between gritted teeth, ‘Thank you Sir. May I have another’ and ‘Remain calm! All is well!’ this must have come as an unwanted early Christmas gift.
But then came an interesting plot twist: confronted with the market debacle they had unleashed, policymakers reversed course. In an unusual move, the official responsible for publishing the proposals was fired and the policy was said to be under further review. In essence, for the first time in years, the government started to signal that it might actually care what equity investors think.
The belief that China was following Japan’s deflationary-bust path: Outside of real estate, the economic data does not paint a picture of an economy that is collapsing. Car sales have been strong, as has internal tourism, while box office receipts recorded record highs in December.
More importantly, China’s real estate bubble was never as big as Japan’s, which helps explain why banks in China are not going bust in droves. Finally, in 1989 at the height of the bubble economy, Japan was 45% of the MSCI World index, which meant that as Japan imploded, foreigners would find themselves selling for years on end. No foreign investor ever had 45% of his global equity exposure in China – and in any case, by now that exposure has been cut to very little.
Granted, these developments are only positive at the margin. None is powerful enough to convince Western investors who have turned their back on China to return. But positive marginal developments combined with very attractive valuations, share buybacks and a pick-up in expected earnings growth could tempt domestic investors and new foreign investors – whether from the Middle East or elsewhere in Asia –to give Chinese equities a second look.
After all, China might appear uninvestible to a US pension fund or a European insurance company, but to a value-conscious Middle Eastern sovereign wealth fund or to the family office of an Indonesian tycoon, China today might look appealing.
Louis Gave is founding partner and CEO at Gavekal Research. This piece was originally published by Gavekal and is republished with permission.