China: Geopolitical risk and your portfolio - Angles & Perspectives Q3 2024

China: Geopolitical risk and your portfolio

Global investors are shunning Chinese equities. September’s Bank of America Global Fund Manager Survey shows ‘short China equities’ to be the second most crowded trade, the most crowded being ‘long Magnificent 7 stocks’. Also in the report, the ‘net % expecting a stronger Chinese economy’ reached the lowest ever recorded level in the survey and geopolitical conflict has ranked as one of the top two tail risks for the past three months.

While emerging markets (EMs) have been deeply out of favour for many years, a dramatic rotation away from China has occurred within the asset class. The market capitalisations of the iShares Emerging Markets ETF (EEM) and iShares Emerging Markets ex China ETF (EMXC) provide a window into this rotation. What is driving this rotation, and have investors actually mitigated their China exposures?

Hard lessons from Russia
Russia made up less than 4% of the EM indices before the Ukraine invasion, but in early 2022 many active EM funds had taken advantage of declining prices to increase holdings of favoured companies, and around 10% Russian exposure was not uncommon.

While the Russian market is best known for energy and mining, there were other interesting listings - for example, banks, retailers and internet companies - with very good long-term track records. As geopolitical fears increased, their share prices collapsed. Active EM managers could not resist buying more. After all, when Russia first invaded Crimea in February 2014, Russian equities declined some 20% in four weeks, but then rebounded and had recovered all the losses by June.

The US-listed VanEck Russia ETF (RSX) illustrates the outcome for foreign investors in Russia this time around. After the February 2022 invasion, prices of Russian stocks collapsed, as did the ruble. RSX’s price fell from some US$25 to under $6, when the share was suspended. A year later it was delisted. So far, investors have received only 68 cents per share in liquidation dividends, implying a devastating capital loss of 97%!

In recent times, investors had not experienced anything like these total losses on their Russian holdings. The event was ‘unforeseeable’ and the investment represented a small slice of portfolios. As such, the outcome could be forgiven by clients. However, should the growing geopolitical confrontation between China and the US result in a similar situation for foreign investors in Chinese stocks, the impact would be hugely magnified.

China risk cannot be ignored
Firstly, China currently makes up about 25% of the MSCI EM Index and Taiwan 17%, so at least 42% of the index is directly exposed to Chinese geopolitical risk. A Russia-like loss for foreign investors would be an existential threat to any products with exposures anywhere near these index weights. Secondly, there are no excuses this time around – the loss is now considered a very plausible scenario with recent precedent. This leads to a consensus view that China is ‘uninvestable’. A manager faces severe career risk if they are not deeply underweight in China or, better still, have excluded China from their benchmark completely. Hence the rotation into EM ex China benchmark products.

Unpacking China risk
China’s economy has been under severe pressure as its policymakers restrict the supply of credit to the property sector. Their strict Covid lockdowns, which extended until late 2022, have also severely damaged consumer confidence. A painful rebalancing of the economy is underway.

In addition to property developers, Chinese authorities have also cracked down on sectors such as for-profit education stocks and the internet giants. The true motivation for this decimation of business models is not clear – presumably, they are seen as a threat to the Chinese Communist Party’s (CCP’s) goals.

Not surprisingly, given this economic and regulatory uncertainty, the equity market has performed poorly. Bloomberg data shows the Shanghai Index has delivered total USD returns of only 6.5% p.a. over the past five years (nearly 80% of which came in the past month after policymakers announced a stimulus programme). On a relative basis, things look even worse. Over the same period, the S&P 500 Index delivered 16% p.a., driven by the Magnificent 7 stocks, which delivered an incredible 47% p.a.!

However, investors should be looking forward. This combination of a very weak economy, extreme pessimism and low stock prices could indicate a very attractive entry point. Many good quality China stocks have wide margins of safety that could compensate investors for these risks. Also, it is clear that Chinese policymakers are deeply worried about growth, and for the first time, appear to be considering directing fiscal stimulus to the household sector. Anything that could improve the deeply bearish consensus is likely to have an outsized impact. The knee-jerk bounce in China equities from the last week in September illustrates this – the Shanghai Index rose more than 20% in five trading days!

Can you mitigate geopolitical risk?
A clear case can be made that carefully chosen Chinese stocks can be considered ‘quality on sale’ and current prices well compensate you for normal economic and jurisdictional risks. But what about geopolitical risk? If China invades or blockades Taiwan, and foreign holders of Chinese assets face a Russia-type scenario, being attractively priced is not enough. Tail risks (which have a low probability of happening but a very high impact) are notoriously difficult to price or manage. If the resulting outcome would be devastating, mitigation by carefully identifying potential exposures, and then restricting them, is essential. Portfolio diversification provides protection.

This sounds relatively straightforward. However, the vast majority of assets are in benchmark-cognisant mandates that closely hug indices. This makes effective mitigation of client exposure to Chinese geopolitical risk very difficult. For example, we mentioned China comprises about 25% of the MSCI EM Index. A benchmark-cognisant EM manager that reduces China exposure to 20% would consider themself as being ‘underweight in China’, and should a Russia-like scenario develop, they will handsomely outperform their benchmark. The client, however, still has 20% of their money at risk and would suffer a significant permanent loss of capital.

China exposure is not just from Chinese equities
The exposure to a China/Taiwan conflict is not just limited to China shares. Taiwan makes up 18% of the MSCI EM Index but 25% of the MSCI EM ex China Index! The EMXC ETF illustrated earlier, which that has grown so rapidly has the benchmark 25% weight invested in Taiwan, and its largest single holding is Taiwan Semiconductor Manufacturing (TSMC) – an incredible 13.5% of the total fund. Despite being an ex-China ETF, a huge slice of the assets still carries Chinese geopolitical risk. However, unlike many China shares, you do not appear to be compensated for the risk by cheap entry prices. TSMC, the world leader in semi-conductor foundry, is a deeply cyclical business which has been a beneficiary of the market buying anything related to artificial intelligence (AI). It is within a few dollars of its all-time high reached earlier this year, and Bloomberg shows it has rerated from a price-earnings ratio (PE) of about 12x in 2022 to a current 28.6x. With the vast majority of its facilities in Taiwan, an invasion or extended blockade would be an existential threat to TSMC.

Hidden China exposure where you least expect it
As mentioned earlier, the Magnificent 7 stocks have driven US equity performance and are considered the ‘most crowded’ trade. Two of these stocks, Apple and Nvidia, are currently the largest components in the S&P 500 Index, with weightings of 7.1% and 6.6% respectively.

Sales in China were about 19% of Apple’s revenue in their financial year ended September 2023. At the operating profit level this rises to 26.5%. However, when considering exposure, we should not only look downstream at customers, but also upstream at the supply chain. We know that some 90% of the most advanced node chips typically used in Apple devices are manufactured by TSMC in Taiwan: suppliers from China and Taiwan make up more than 76% of Apple’s cost of goods sold (data from Bloomberg Supply Chain Analysis). We can conclude that Apple’s supply chains are deeply imbedded in China and Taiwan, and while the company’s strong balance sheet and services business (22% of revenue) should ensure survival, we believe product sales (78% of revenue) would decline by 80% to 90% should their access to their existing supply chain be compromised for an extended period.

In Nvidia’s case, some 39% of sales were in China and Taiwan in their financial year to January 2024. However, the upstream analysis is even more devastating than Apple’s. Almost all their chips are manufactured in Taiwan (estimated at more than 90%) and they do not have a comparable services business. A Chinese invasion or extended blockade would be an existential event for Nvidia.

The index itself can be risky
Most investors believe the benchmark index to be by definition a ‘low risk’ equity portfolio, and it is deviations from the benchmark that are risky. This depends on the index being a fundamentally well-diversified portfolio. When indices are dominated by a handful of sectors or holdings, this is obviously false. Many investors are unaware that index composition varies significantly over time. Even the world’s most significant market, the S&P 500, has periods when price momentum results in the index being dominated by very overvalued companies (e.g. 1972/3 Nifty 50, 1999/2000 TMT bubble, and we would argue currently). In this environment, contrary to how most market participants quantify risk, hugging the benchmark in reality exposes investors to very significant risks.

The S&P 500 Index gives you significant Chinese geopolitical risk exposure
We have seen many market participants declare China ‘uninvestable’ given the rising geopolitical risks of a Taiwanese conflict. They may be correct, but that same reasoning would seem to contradict owning the two largest S&P 500 Index components, Apple on 35x earnings and Nvidia at 61x earnings. Should they lose access to their greater China supply chains neither of these Magnificent 7 companies has a business model that would survive in its current form. Of course, there are many other large stocks in the S&P 500 Index that are also dependent on greater China-integrated supply chains and Chinese customers. The problem is by no means isolated to the top two stocks.

Ensure you are being compensated for the risks you take on
When evaluating their exposure to Chinese geopolitical risk, investors should look further than China stocks. A Chinese invasion or blockade of Taiwan would be a devastating geopolitical event, with existential ramifications for huge index components such as Apple, Nvidia and TSMC. Given the risk embedded in the index giants, an investment process that is benchmark cognisant (i.e. almost everyone) will battle to diversify exposure to Chinese geopolitical risk without introducing significant tracking error.

Our portfolios consist of our best ideas from the universe of liquid stocks, and we are not beholden to any index (refer to our articles SA Inc under the microscope and Positioning global portfolios for the next generation of opportunities for more insights into our thinking). We do not see China stocks as uninvestable, but require generous compensation for the risk taken and, secondly, carefully monitor overall China exposure. Contrast this with closely tracking the S&P 500 Index. This currently has the unintended consequence of taking a massive bet on Chinese geopolitical risk with no corresponding price discount. If there was ever a time to apply some creative ‘common sense’ to your equity risk management process, it is now.