Extreme volatility in China’s stock markets, and the drastic measures taken by the government to quell it, have reminded emerging-markets portfolio managers of the vulnerabilities of this key global market.
Nevertheless, portfolio managers such as Roger Aliaga-Diaz, economist with U.S.-based fund giant Vanguard Group Inc. in Philadelphia, are convinced of China’s positive long-term potential and remain committed to investing in the country.
Aliaga-Diaz says that although China is now the world’s second-largest stock market (based on the market capitalization of listed companies), it’s still an immature emerging market undergoing typical “growing pains.” On average, China’s market volatility during the past 15 years has been in line with many other emerging markets, he says.
“China represents a large and growing slice of the global economy,” says Aliaga-Diaz. “The country is moving forward with reforms, but it’s going to be a bumpy, gravel road rather than a smooth ride. It will be two steps forward, one step back – and sometimes one step forward, two steps back.”
After the Shanghai composite index peaked in June, the bubble burst suddenly and the index dropped rapidly, by about 32% in four weeks, before dramatic intervention by authorities stemmed the sell-off and launched a fragile recovery. The index has bounced about since, and hovered about 28% below early summer highs in mid-August, but still ahead by 38% year-to-date.
“We anticipate that the worst is behind us and are generally constructive on China,” says Christine Tan, senior portfolio manager with Excel Funds Management Ltd. of Mississauga, Ont., and portfolio manager of Excel Emerging Markets Fund, which currently has a 20%-25% exposure to China.
Currency swings also are characteristic of emerging markets. The yuan declined by 2% against the U.S. dollar (US$) in August and may decline further as authorities move the currency away from its soft peg to the US$ toward a freer floating yuan.
Currency hedging
Canadians investing in China may choose to hedge the yuan or choose hedged versions of mutual funds and exchange-traded funds. Tan says she has used hedges to neutralize Chinese currency exposure for the past few months because of concerns that the yuan was too strong relative to other non-U.S. currencies.
The excessive stock market intervention by the Chinese government raised some concerns, Aliaga-Diaz says, but he expects there will be less artificial support as longer-term economic reforms gradually come into play and markets stabilize.
The mainland Shanghai and Shenzen exchanges provide access to more small- and medium-cap companies than the more established and stable Hong Kong exchange, he adds, and broader opportunities to capitalize on Chinese growth. Later this year, Vanguard will be adding Shanghai-listed Class A shares to some of its emerging-markets products.
“The idea of index investing is to reflect what’s happening in capital markets, not to avoid it,” Aliaga-Diaz says of Vanguard’s approach. “The volatility may deter some people, but it’s not different from any other emerging market. It’s important that investors understand the nature of the asset class.”
As recently as mid-2014, China was one of the undervalued markets in the world, Tan says. However, in the autumn of 2014, China’s stock market began a rapid ascent as the government opened the market to international investors through an access arrangement with the Hong Kong exchange. Jumping on the bandwagon, inexperienced local investors began to buy indiscriminately and increase margin loans, further fuelling the fire. Government warnings of the dangers of speculation fell on deaf ears, and the Shanghai index rose by 150% before the crash in June.
At that point, regulators switched gears and jumped in to stop the drop by suspending trading in some companies and allowing others to halt trading of their stock voluntarily. The government also offered liquidity to brokerage firms, propped up demand with government pension plans, restricted short-selling and ruled that investors with more than 5% of a company’s stock couldn’t sell for six months.
“Was [the government’s actions] intervention? Absolutely,” says Tan. “Do I like it? Not at all. It was an effort to mute volatility. Other governments, including the U.S., have used indirect measures to provide liquidity to markets, but the Chinese approach was less elegant and more blunt.”
Economic growth
China’s gross domestic product (GDP) is growing still, although it has slowed from its previous breakneck pace of more than a 10% a year. Future annual economic growth could be 6%-6.5%, which is healthy for the larger economy that China has become, with its current annual GDP of US$10 trillion.
Kara Lilly, investment strategist at Mawer Investment Management Ltd. of Calgary, says Mawer’s global portfolios have no exposure to China. She says it’s hard to find companies that meet Mawer’s strict criteria of being well managed by experienced teams, good allocators of capital and attractively priced. She adds that investors may be more wary after recent government interference and trading restrictions. China says it wants to liberalize its financial markets, but has indicated an unwillingness to accept the consequences, she adds.
“It’s not much of a market if people are unable to buy and sell,” Lilly says. “The Chinese model may ultimately be different from the Western model, and recent events remind us that we’re dealing with a government that has its own way of doing things.”
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