Is China driving volatility?

Today we take a look at what’s going on in China’s economy and how recent developments might affect their financial markets—and ours.

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From Thrivent Asset Management, welcome to episode 18 of Advisor’s Market360™. A podcast for you, the driven financial advisor.

2021: a year of cautious optimism, a struggle to return to normalcy amidst continued hardship. Economically, this final quarter of 2021 has started out following this trend, with plenty of areas of concern for U.S. investors: the effect of the surging delta variant, which is showing signs of impacting economic activity; the prospect of rising personal and corporate tax rates; the potential of diminished monetary support from the Federal Reserve and persistent supply chain issues which could diminish growth. Yet another concern has been developing in recent months, and its immense influence can be felt from the other side of the globe: China.

The MSCI China Index, which measures large- and mid-cap representation across a variety of Chinese shares and chips, had surged to start the year as “reflation” hopes prevailed. Since then, it has now fallen into a disconcerting bear market, down over 17% year-to-date. By comparison, the U.S. stock market has increased steadily throughout 2021. The S&P 500 Index®, tracking the average performance of 500 large cap stocks, is up more than 19% through late September.

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So, what’s behind China’s bear market? Many believe it’s being driven by shaky real estate.

For many years, there has been skepticism regarding the real estate market in China.  Huge amounts of capital, much of it borrowed, has been pumped into building entire cities. Massive, multi-family structures were built with the belief they would be occupied in short order as the country became more urbanized. Significant real estate debt problems are now surfacing in China, echoing the real estate bubble that fueled the 2008 financial crisis in the U.S.

A major real estate player in China with total debt of over $300 billion, Evergrande, is in crisis mode. To put this in perspective, the Lehman Brothers default, which is considered to be the catalyst that led to the market collapse in 2008, had total debt of roughly $600 billion. Evergrande is not alone: there are other large Chinese real estate companies that may have similar problems. As for Evergrande, it appears that a restructuring and possibly default may be imminent. However, it’s unclear what a resolution to this debt problem will look like given the very different environment in China, from legal, regulatory, market, and political standpoints.

For now, it doesn’t seem likely that the implications of China’s real estate problems will reverberate throughout the entire global financial system, but it will impact economic growth in China. And, given China’s size and influence as the world’s second largest economy, it has the potential to also affect economic growth and commodity markets elsewhere. Given the opaqueness of this problem and the uncertainty this causes for investors, it is likely that this problem will persist as a depressing element to equity market valuation in China, as well as other emerging markets.

As mentioned previously, these developments could lead to a downshift in Chinese growth – at least in the near term, if not longer. Although growth in China is still expected to be higher than developed countries, it may not be as robust as it had been in the past. That, in turn, could have an adverse effect on other parts of emerging markets that trade with China, not to mention the developed markets of the world. And the consolidation of authority under President Xi Jinping, along with shoring up his “base” by addressing income inequality, could mean continued confrontation with the U.S. Over time, it may even increase the odds of an event, such as an attempt at retaking Taiwan or a mistake in the South China sea.

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China and Western democracies have similar problems, but vastly different approaches to solving them. Let’s rewind a bit…

Economies around the world have shifted dramatically over the past 50 years, from being driven by labor, natural resources, and manufacturing, to now being driven by capital, information, and services. These changing dynamics have contributed to significant disparities in income and wealth distribution around the world.

Environmental, social, and data ownership—and its security issues—have also become key problems that governments feel compelled to address. Finally, a very small number of information-based corporations have amassed such economic influence that governments are closely scrutinizing them and considering regulations to constrain their power.

In the U.S., and for Western developed countries as a whole, these issues are addressed in what can be a messy, inconsistent, and slow democratic processes. Regulation, government institutions and tax policy are the key tools that Western democracies use to address issues. The approach by Western democracies is incremental, iterative, and oftentimes contentious and inefficient. Although this approach can certainly hinder timely and optimal approaches to problems, it rarely involves direct insinuation of government intervention into corporate activities.

This is not the case in China, where its one-party Communist rule can be used in a vastly different manner than in the West.

China, led by its powerful President Xi, also feels the need to address income and wealth disparities, as well as a host of other social, financial, and political challenges. In addition, it has a unique demographic problem of a rapidly aging population, following decades of its disastrous “one child” policy.

China’s minimal social safety net programs are not prepared for the dramatic increase in older citizens that will require support. Unlike Western democracies, China is responding to these challenges by insinuating its authoritarian power in the structure of the Chinese economy and markets. It has directly cracked down on large corporations and industries in an attempt to change their strategic direction such that all economic entities will contribute to “common prosperity” and “socialism with Chinese characteristics.”

This has meant re-directing corporate profits for broader social needs, changing financial market regulations, and trying to reshape industries, such as the large private tutoring and gaming industries, so that they align with the goals of the government and the party.

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So how will the market react to the situation in China? Will it be transitory or secular?

Global investors were caught off guard by the swiftness, magnitude, and breadth of the actions that Chinese authorities took to alter the mission and strategies of very large Chinese companies and industries. There is concern that profits from many large public companies will be diverted from shareholders to aid in the funding of social programs. There is also concern over significant regulatory changes that could seriously impact the financial model of entire industries, such as the for-profit education and gaming sectors.

In addition to profit concerns, there is the potential that such heavy-handed policies regarding business and markets will have a very damaging effect on the innovative drive of Chinese entrepreneurs. This, too, will weigh on Chinese market valuations.

China has proven over centuries, if not millennia, that it can play “the long game.” The governing party is intent on preserving social stability and political control, even at the expense of near-term economic growth. Furthermore, President Xi seems intent on becoming one of China’s transformational rulers, similar to Chairman Mao. His nationalistic and populist moves are aimed at garnering widespread approval of the common citizen, while curtailing the influence of corporations and the ultra-wealthy class of Chinese citizens.

For many years, corporations and investors have viewed China, with its enormous population and manufacturing capacity, as an attractive opportunity. Investment dollars flowed into the country, significantly contributing to the rapid growth of the Chinese economy. However, investors are now questioning this China narrative and examining other details of the investing environment.

One disconcerting detail that investors are now focusing on is the question of what ownership in Chinese equities really means. Direct foreign investment in Chinese companies is prohibited by Chinese law. In response, corporations and investment banks have developed “work arounds” such as Variable Interest Entities or VIEs, that provide investors with essentially indirect ownership of shares in Chinese companies. However, these “work around” structures are rather opaque and offer no shareholder’s rights at all. Another major issue is the question regarding the integrity of accounting and auditing standards applied to Chinese companies. The Securities and Exchange Commission is now examining this area as it tries to provide more information and clarity to corporate disclosures.

In summary, it appears all these developments are not transitory but are secular in nature. From a near term perspective, the Chinese central bank will provide liquidity to soften the impact of not only actions being taken to resolve the real estate debt crisis, but also the new initiatives being taken to promote Chinese “common prosperity.” These developments, however, will have long-term effects not just on the Chinese economy and markets, but also on emerging markets overall given the heavy weighting of Chinese-oriented securities in those indices.

Within Thrivent’s mixed asset funds, we remain underweight in emerging markets equities given decelerating growth in China, the government’s ongoing aggressive intervention across multiple sectors, and the country’s large weighting in emerging markets indices. More broadly, we are positioned modestly overweight in equities with a preference for domestic equities.

This special report on China was prepared by Steve Lowe, CFA, Chief Investment Strategist with help from Sharon Wang, Senior Equity Portfolio Manager; Jing Wang, Senior Equity Portfolio Manager; Nick Cai, Senior Equity Portfolio Manager; and Yifang Cao, Director, Fundamental Equity Data Science.

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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.

(Disclaimers)

All information and representations herein are as of September 28, 2021, unless otherwise noted.

Any indexes discussed are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Investing involves risks, including the possible loss of principal. The prospectus and summary prospectus contain more complete information on the investment objectives, risks, charges and expenses of the fund, and other information, which investors should read and consider carefully before investing. Prospectuses are available at thriventfunds.com.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.