After considerable internal discussion, the Investment Committee at WT Wealth Management has decided to modify our approach to Emerging Market exposure in applicable portfolios by excluding investment in China-based entities. This circumstance provides a good educational opportunity for our clients to see behind the curtain of our investment analysis process.

China

When investing in an Emerging Market mutual fund or ETF, China is typically the single largest country allocation, making up 35-40% of the overall country weighting. ⁽¹⁾ When Chinese companies do well, this becomes an obvious driver to the success of Emerging Market portfolio holdings. However, when Chinese companies are at risk, performance can swing dramatically the other way.

Investors have been told for years about the benefits of investing in China. Such benefits include: diversification from Europe and North America, the low correlation of the Chinese markets with other major markets, the country's economic size, the surge in its huge middle class, and the development of proprietary "made-in-China" science and technology. These potential benefits should not be dismissed.

However, it can be easy to forget that China is a communist country ruled by an authoritarian regime. The Chinese government's recent crackdown on privately owned companies and entrepreneurs has captured the world's attention. As China implements a more restrictive regulatory and governance attitude on everything from schools to companies involved in media and entertainment – often abruptly and without recourse to appeal – investors in Chinese assets will have to weigh the risks more carefully.

Authoritarian Risks



In the short-term, Beijing is compounding investors' concerns by putting a new emphasis on a longstanding political slogan — "common prosperity" — to focus attention on the country's deep inequality and put some socialism back into the term "socialism with Chinese characteristics". ⁽²⁾

The rapid growth of Chinese tech companies over the past decade has elevated many of their founders to celebrity status... much like Mark Zuckerberg, Elon Musk or Jeff Bezos in the United States. Alibaba founder Jack Ma became increasingly well-known globally, a star in the making, and was regarded as China's greatest entrepreneur and business figure. But the ruling Chinese Communist Party does not like it when private citizens begin to overshadow its own success or newsworthiness. At least half a dozen Chinese billionaires, entertainers and business leaders have disappeared from the public spotlight in the past year after getting on Beijing's "too popular" radar. Ma became the poster boy for that as he vanished from public view for nearly 9 months. He's now "back," but has become more docile than before and has made few public appearances with far less fanfare. ⁽³⁾

Other crackdown reforms made headlines this past summer when Chinese authorities announced that they were banning for-profit educators from actually turning a profit, going public, or raising capital from foreign investors. China feared the acceptance of foreign capital would mean foreign stakeholders could have influence over decisions regarding the companies' curriculums. That's not something the authoritarian party was willing to accept. ⁽⁴⁾

Then in September, China adopted new regulations governing how much time minors can spend playing online video games – restricting young people to just 3 specific hours per week: between 8 and 9 p.m. on Fridays, weekends, and holidays. The official press release stated the video game restrictions are a part of an effort to create healthy youth who are disciplined, studious and nationalistic. All companies are expected to enforce the regulations, so firms involved in the video-gaming industry have no real choice but to endorse the state's new impositions. ⁽⁵⁾

After decades in which domestic, private businesses were encouraged, China is moving sharply leftward and reconnecting with its Marxist roots. It is apparent this current campaign against private entrepreneurs and companies is in stark contrast to its previous, more westernized business climate. Not surprisingly, this authoritarian crack-down has triggered a precipitous fall in the stock market valuations of several China-based companies.

Fundamental Risks



In the medium term, another key issue is the sustainability of China's economic development model. Rising headwinds from indebtedness, poor demographics, stalled productivity and the harshest political environment since the Mao era are undeniable challenges.

China is also struggling with a severe shortage of electricity which has left millions of homes and businesses hit by power cuts. Concerns over the power cuts have contributed to global investment banks cutting their forecasts for the country's economic growth. Goldman Sachs has estimated that as much as 44% of the country's industrial activity has been affected by power shortages. ⁽⁶⁾

Geopolitical Risks



Lastly, issues like the origins of the coronavirus, human rights violations of Uyghur Muslims, Taiwanese sovereignty, geopolitical tensions in the South China Sea and alleged state-sponsorship of cybercriminals are all stumbling blocks in the way of Chinese companies expanding internationally and gaining global acceptance.

Conclusion



Given the Chinese Communist Party's recent about-face, we feel that while once rife with opportunity, investing in China has become a risky proposition requiring a major leap of faith in Chinese politics, totalitarian governance, "common prosperity" and the future of an economy faced with a multitude of fundamental economic hurdles.

To investors, and the advisors who guide them, what matters most is whether Chinese companies can deliver profitability and growth in the current environment. Frankly, China-based companies are faced with immeasurable risk. And markets are never comfortable with things that are immeasurable – usually leading to downward pressure on equity prices.

All of the above benefits and risks were considered in the WT Wealth Management Investment Committee's ultimate decision to eliminate China-based investment. We will continue investing in Emerging Markets, but without China exposure for our clients.

We always welcome your questions. So please reach out to your advisor to discuss and learn more.


Sources

1. Emerging Markets
   msci.com
   
   
2. Socialism with Chinese characteristics
   wikipedia.org
   
   
3. Chinese tech billionaire Jack Ma hasn't been seen in nine months
   news.com.au
   
   
4. China crackdown on tutoring sector leads to protests
   aljazeera.com
   
   
5. In China, Kids Are Limited To Playing Video Games For Only 3 Hours Per Week
   npr.org
   
   
6. China power cuts: What is causing the country's blackouts?
   bbc.com