Our Take on China’s ‘Bear Market’

Over the past month, Chinese stocks have gotten a lot of media attention—a subject that mostly centered on a handful of firms and got very company-specific. As such, we chose not to delve into it on these pages, as we don’t make individual security recommendations and will touch on specific companies only when they represent a broader theme worth highlighting. But last Friday, the tenor of global media coverage changed considerably, focusing on the bear markets that materialized first in the MSCI China Index, then in Hong Kong’s Hang Seng Index, which includes several mainland Chinese listings. So we think it is time to take a broad look at what has been going on, whether the downturn stems from sentiment or deep negative fundamentals, and explore where long-term investors with Chinese exposure go from here.

Most of the developments and volatility preoccupying investors have occurred over the past month, stoked either directly or indirectly by regulatory announcements from various Chinese officials. Since July 22, the day before rumors first broke that regulators were about to drop tough new rules on online private tutoring companies (rumors that soon came true), the MSCI China is down -15.6%.^[i] But the downturn actually started back in mid-February, in the wake of some very high-profile cheer about Chinese IPOs. To us, that environment seemed a tad frothy, but market fundamentals appeared overall strong. China’s economy was growing swiftly, buoyed by the domestic and international recoveries from lockdowns alike. When COVID flared in cities now and then, renewed restrictions didn’t appear to have much broader economic impact. Accordingly, the -18.5% drop from February 17 through March 25 seemed to us like a classic correction: sharp, sudden and sentiment-fueled.^[ii]

Throughout the spring and first half of summer, Chinese stocks bounced overall sideways. Not the classic V-shaped bounce that usually follows corrections, but also not a continued freefall. A brief dip into bear market territory in mid-May reversed quickly. But then came the regulatory ruckus in July and August, leaving the MSCI China Index down -32.2% from its peak as of Friday’s close.^[iii] A bear market in magnitude.

But does it stem from sentiment or actual forward-looking negatives—including possible Chinese economic troubles? There is undoubtedly a cloud of regulatory uncertainty, but based on what various government arms have announced so far, we think investors are extrapolating small developments into huge fears. For one, the worst of the volatility is confined to offshore-listed firms. As Exhibit 1 shows, mainland-listed A-shares, though following a similarly rocky path, are down only -12.2% from their February 10 peak (ahead of the week-long Lunar New Year stock market closure)—and they are actually up a bit from their own March 25 low. The A-share universe is leveraged heavily to domestic fundamentals, so for now, that gauge isn’t signaling something deep and ugly economically, in our view. Moreover, all the economic data roiling analysts last week is backward-looking and has been widely known for a while now. The surprise power here seems minimal to us.

Exhibit 1: Dueling Chinese Pullbacks

Source: FactSet, as of 8/20/2021. MSCI China and MSCI China A Onshore Index returns with net dividends, 12/31/2020 – 8/20/2021.

That leaves offshore-listed stocks, which are primarily large Internet and Financials companies. The initial rout looked entirely like an overreaction to the crackdown on tutoring companies. In fairness, that crackdown was severe and fundamental. Overnight, regulators converted them to non-profits, mandated lower fee schedules and banned foreign ownership. This naturally shook sentiment, but in our view, the indiscriminate selling of companies outside this sector was overblown. It reeked of fear of the unknown—big rules that weren’t even part of the rumor mill—rather than careful consideration of the likely reality.

The next month brought more regulatory pronouncements, many centered on Internet firms, and more overreaction. The associated fines and regulatory changes were tiny, and the affected companies had already signaled voluntary compliance, but the deeply pessimistic mood remained, and we think it blinded investors’ view of the fundamental landscape. The same argument applies, in our view, to the way markets greeted the new privacy regulations announced Friday—basically China’s version of Europe’s General Data Protection Regulations, which you might know as the rules forcing every website on earth to display an annoying pop-up asking about cookies. The precise legislation isn’t public yet, but the announcement on state-run media alluded to new guidelines for collecting user data as well as bans on using data and algorithms to manipulate users’ choices (i.e., data-driven product placement favoring a house brand over a competitor, discriminatory pricing based on a user’s profile, etc.). These general items were already part of the anti-monopoly rules that have been under continual refinement for a long while, which again underscores the role sentiment is playing, in our view.

The primary forward-looking item now is the government and state-run media’s repeated references to “common prosperity,” which many fear heralds a return to full-fledged socialism, undoing all the market-oriented changes that have happened since Deng Xiaoping was in charge. Repeat references to higher wages and large companies’ treatment of workers seemingly underscore the fears, according to many analysts.

Harmful government meddling is always a risk in a command and control economy, so we get where everyone is coming from. But we also think some perspective is in order. While Chinese officials may pay lip service to socialistic platitudes, we doubt their primary goal has changed. That goal: Ensuring social stability by engineering ever-increasing, ever-more widespread prosperity. Key to this effort is the long-running shift to consumer and Tech-led economic growth, moving away from the historical reliance on heavy industry and exports, with all of the latter’s inherent economic sensitivity. An economy dominated more by large growth-oriented companies tends to weather the cyclical ups and downs better. Even with the government’s recent jawboning about returning some emphasis to manufacturing, cracking down on Tech in the manner investors fear would amount to killing the goose that laid the golden egg.

For investors with Chinese exposure, we suggest approaching the recent volatility much the same as we would any similar pullback anywhere else in the world, whether in Emerging or developed markets: What is the fundamental likelihood that more severe downside lies ahead? What big negatives are left that no one is talking about today? Absent something severe, new and shocking, we don’t think there is much reason for material further downside. Predicting the precise low point of a downturn is as impossible as predicting its peak, but we think that at times like this, if you have already absorbed the downside, the most beneficial move is usually to hang on and reap the recovery that follows.

In our view, the primary risk for investors with Chinese exposure right now isn’t further downside, but getting whipsawed by making a knee-jerk reaction to a decline that already happened. Past performance isn’t predictive, and stocks aren’t serially correlated—trends last until they don’t, and one day’s movement doesn’t predict the next. But recoveries have always followed corrections, and bull markets have always followed bear markets. We suspect that basic logic applies now to China, which should benefit Chinese stocks broadly.

Again, we can’t say for sure when that recovery will happen. But the mood late last week looked an awful lot like capitulation, with every seeming negative in China generating oodles of headlines. We saw it with the regulatory wrangling. We saw it with the reaction to economic data. And we saw it with all the talk about weak steel production and property investment hurting oil and commodity prices. When sentiment gets this down in the dumps, it doesn’t take much for reality to start beating expectations, even if that reality isn’t perfect.