What should we do with Chinese stocks on fire-sale?

TL;DR

• Chinese stocks have sold off sharply due to concerns that the market has become “uninvestable” with rising risks.
• These risks include its alignment with Russia in an evolving global political landscape, continued regulatory risks, and rising domestic Covid-19 cases.
• While Chinese stocks are looking cheap, it is hard to say that we have seen the bottom.
• Some of the indicators that Beansprout would be looking out for include (1) no spillover of sanction risks to China, (2) stabilisation in Covid-19 situation, and (3) government policy support.

What happened?

If you are an investor holding on to any Chinese stock, the past week would have been particularly painful. Whether is it e-commerce giant Alibaba (which Charlie Munger recently bought into), or emerging electric vehicle manufacturer Nio, we have seen that there was nowhere to hide as Chinese stocks saw a sharp sell-off. 

Notably, Chinese ADRs have lost close to 70% since their highs in February 2021, wiping out more than US$2 trillion in value for Chinese tech and internet names. The Hang Seng Index (HSI), a well followed benchmark for HK equities, is nearing its 10-year lows.

Due to numerous risks faced by investors, global investment bank JP Morgan has called some Chinese internet names “uninvestable”.

What does this mean?

The sharp correction was driven by a combination of several factors which have come together at the same time. These would include:

• Rising geopolitical risk with spillover effect from the Ukraine Crisis
• Ongoing regulatory risks
• Concerns of economic slowdown with spike in Covid-19 cases

a) Geopolitical risks

The Ukraine Crisis has shone a spotlight on geopolitical risks, as investors weigh the impact of a shifting global balance between the key economic blocs. After all, we have seen the significant impact that Western sanctions have had on Russia’s financial system, especially after the restriction of certain banks from the SWIFT network. 

There are increasing concerns about the spillover of sanction risks from Russia to China, especially as China is Russia’s largest trading partner at the country level. 

This comes following a report that claims that Russia has asked China to provide military assistance in the Ukraine War. While China has denied the report, investors are still concerned that Chinese relationship with Russia could eventually lead to a backlash against Chinese companies. 

b) Chinese tech regulatory risks

On top of geopolitical risks, the regulatory risks faced by Chinese firms remain unabated. This comes as the US Securities and Exchange Commission (SEC) has identified five Chinese companies, including Yum China, that could be delisted if they do not open their books to US regulators. 

The potential delisting of the Chinese companies from the US market has also reignited concerns about a financial decoupling between China and the West, which started during the US-China trade war. 

Domestically, Tencent was reported to be facing a potential record fine for violation of money laundering rules, while Didi Global’s planned IPO in Hong Kong was reportedly cancelled after it failed to meet requirements. 

c) Covid risks

To make things worse, China is facing its worst Covid-19 outbreak since April 2020, leading to further concerns about how this will affect domestic consumption and global supply chains. 

China has always stood out from the rest of the world due to its zero-covid policy. While the rest of the world has seen a surge in Covid-19 cases with the Omicron variant earlier, China has been able to keep cases under control with its strict testing and lockdown regime.

However, this strategy has been put into question with the spike in cases in recent weeks. On 15^th March, China reported 3,602 Covid cases, a sharp increase from the 1,437 cases reported on the previous day. 

China has placed 17.5 million residents in Shenzhen in a lockdown, which has led Apple’s supplier Foxconn to suspend iPhone production in the city. While Chinese state media has said that there is no need to lockdown Shanghai for now, many flights into and out of the city have already been canceled. 

What would Beansprout do?

Valuation is cheap, but hard to call the bottom. It is hard to argue against the idea that Chinese stocks are cheap right now. MSCI China is now trading at a forward price-to-earnings ratio of below 10x, which is why investment bank Goldman Sachs has said that “investors should make money in 12 months”. 

However, as we have seen over the past months, attractive valuation is not sufficient reason to suggest that the market has bottomed. Based on the factors driving the selldown in the market described above, we would be keeping a lookout for the following: 

• Geopolitical developments: In this regard, the Chinese response to the Ukraine Crisis, and how the West perceives China to be aligned with Russia would be key to watch. For now, China has denied US claims that Russia has asked China for military equipment in the Ukraine war. It would be key that the situation does not escalate further, such that sanctions are imposed on Chinese companies as well. 
• Covid-19 cases: Given the concern that the lockdowns in several Chinese cities could affect global supply chains and push inflation up higher, we would be looking out for a stabilization in the pandemic situation in China. 
• Chinese policies to support economy. The Chinese government has been able to come up with measures to support the economy during past periods of slowdown, and it is worth keeping a lookout for whether any fiscal stimulus measures are announced shortly. For example, they could push for more infrastructure spending like during the Global Financial Crisis in 2008. Also, it remains to be seen if there will be a respite in the regulatory clampdown on the tech sector.

In the near term, the Hang Seng Index has broken near term support levels, and the next key level to watch is its 2016 low of 18,278.80.

It is important to have a sound investment plan and do not panic during a selldown. After all, the correction could eventually present opportunities for investors who have patience and can afford to take a longer-term view of the market.