Avoid This Investment Mistake on China

Summary

• Many investors confuse economic growth for likely stock market performance, especially for China.
• But China’s constitution and political system does not favour the private sector, unlike the US’s.
• We would therefore prefer to be structurally long China sovereign bonds than China equities.

The Chinese New Year starts tomorrow with the advent of the Year of the Tiger. Asia markets may therefore be less liquid than normal, which international investors should recognize. But this is not the only thing investors should consider. More important are the power dynamics within China compared with the US. The most crucial one is that China is ruled by a single party, the Communist Party of China (CPC), which has a very specific constitution.

What Do the Constitutions of China and the US Reveal?

China’s constitution opens with, ‘The Communist Party of China is the vanguard of the Chinese working class, the Chinese people, and the Chinese nation’.

And to guide its action, it uses ‘Marxism-Leninism, Mao Zedong Thought, Deng Xiaoping Theory, the Theory of Three Represents, the Scientific Outlook on Development, and Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era’.

Xi Jinping Thought was formally outlined at the Party’s 18^th National Congress in 2012. It was then elaborated on at the 19^th National Congress in 2017. In President Xi’s speech, he outlined the 14 principles, and the top of the list is the following:

‘1. Ensuring Party leadership over all work. The Party exercises overall leadership over all areas of endeavor in every part of the country. We must strengthen our consciousness of the need to maintain political integrity, think in big-picture terms, follow the leadership core, and keep in alignment. We must work harder to uphold the authority and centralized, unified leadership of the Central Committee, and closely follow the Central Committee in terms of our thinking, political orientation, and actions.’

This gives a very clear sense that power and the rewards associated with it would accrue to the Party and state machinery rather than the private sector.

Meanwhile, the US constitution states the following through its amendments. The First Amendment says, ‘Congress shall make no law … prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press’. And the Fifth Amendment says, ‘No person shall… be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation’.

This gives significant power to the private sector in the US, which can then dominate policy. And since 2010, a new legal interpretation of the constitution, Citizens United, has allowed US companies to exercise their free speech and make unlimited funds available for political campaign advertising. This has significantly increased the contributions from large companies to political candidates. The power dynamics in the US are such that the private sector, often large companies, can dominate and accrue all the rewards. That is, the powers lie with the owners of capital, capitalists.

The Link Between the Economy and Stock Markets

This power dynamic is starkly evident in the link between the economy and stock markets. In capitalist America, since 2010, the US economy has grown 56%, yet the stock market has grown 297% (Chart 1). That means the companies were able to generate higher profit growth than economy-wide growth. This was likely due to driving down costs such as wages, expanding into international markets, reducing their tax bills and clever use of leverage and stock buybacks. It also helped that interest rates were lower, which allowed multiples to increase. Shareholders and capitalists have therefore been the big winners.

In communist China, it was the opposite. China’s economy grew by a whopping 232% since 2010 (Chart 2). Meanwhile, Chinese stocks cumulated gained a paltry 28%. Here we see that shareholders did not benefit massively. Rather, the public sector has grown significantly, and workers’ wages have increased.

For investors, then, understanding the political economy of countries is crucial. This allows us to determine which asset class will benefit from a growing economy. In the US, it is clear stocks will generally benefit from economic growth and even outpace it.

Meanwhile, for China, the clearest beneficiary of economic growth is the state and public sector, which in turn suggests Chinese sovereign bonds are most attractive. The state will always ensure the bonds are liquid and creditworthy.

But China stocks are less clear-cut. There may be bouts of outperformance, or certain sectors may do well, but the political economy leaves it unclear whether rising stock markets are a political imperative. We would therefore be cautious in value-based arguments to be structurally long China stocks. Instead, the structural long should be sovereign bonds. Finally, remember that while the Year of the Tiger can be characterised by confidence, it can also be associated with unpredictability.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)