With China’s rapid rise in the global economy and financial markets, how should investors be thinking about exposure to China in their portfolios — especially against a backdrop of heightened geopolitical rhetoric?
Capital Group Vice Chairman Rob Lovelace and portfolio manager Chris Thomsen addressed these opportunities and challenges in a recent webinar. Here we share some insights from them, along with emerging markets investment director Kent Chan, into China’s diversifying economy, geopolitics and potential implications for investment portfolios.
Rob Lovelace: I think the defining moment of China’s rise was the global financial crisis of 2007‒2009. Before then, there was a lot of debate within China about the extent to which they would pattern their economy and capital markets after the U.S. and Europe. The global financial crisis shattered confidence in the Western model and led to more support for a nationalistic model.
Under Xi Jinping, China has pursued an economic policy that's very independent from the rest of the world. This became clear with the Communist Party’s 2015 five-year plan, which in some respects was really a declaration of independence. China is taking a path of self-sufficiency in areas such as technology and science. Looking ahead, I believe China is well positioned economically and is poised to grow its capital markets and attract more foreign capital.
China’s gross domestic product is edging closer to the U.S.
On the flip side, we’re clearly in a more confrontational period in terms of geopolitics. And many investors are struggling with the best way to gain exposure to China.
I believe investors should think through their strategy on how they want to get that exposure. Is it through investing in multinationals that do business there? Is it investing directly in large China companies that are listed around the world? Or, is it investing in China’s domestic A-share market? Whatever their comfort level, investors have to decide.
Lovelace: I would call the period we are now in a conscious uncoupling. While there is unlikely to be a significant shift in the relationship under President Biden, I expect both parties to remain at the negotiating table.
China has a very clear objective. It wants to be strong, independent and in a better position to limit foreign influences. U.S. policy has not been as coordinated, and the U.S. is still debating what it wants out of the relationship. Europe is going through a similar struggle. However, relationships between these regions are intertwined. China is linked to the West through assets; for instance, it holds about a trillion dollars of U.S. debt. And the West is linked to China through trade. These interdependencies indicate that it is in everyone’s best interests to keep talking, because completely decoupling is not going to be possible.
China’s key economic priorities (2021‒2025)
Chris Thomsen: Over the past 25 years, every time I’ve been to China I’ve been amazed by the pace of change. Its skylines, airports and subways are world class. I expect China to continue its impressive evolution from factory of the world to a modern economy driven by innovation, technology, the rising middle-class consumer and pioneering new services.
The millions of patents China has granted and the level of spending on research and development relative to other countries are fueling innovation, disruption and growth. And for investors, this is rapidly expanding the number of potential investment opportunities, particularly for small- and medium-sized companies.
China has accelerated R&D push
In portfolios I manage, I am not that focused on state-owned enterprises. I prefer entrepreneur-led companies across many industries, from e-commerce to fintech to software and health care. Many of these are now multibillion-dollar companies that weren’t even publicly listed five to 10 years ago.
The biopharmaceuticals industry is one example. A large number of Chinese scientists who were educated and/or employed in the U.S. and Europe have been returning from overseas to help create world-class companies involved in drug development, testing and manufacturing. The growth has been astonishing. This is an industry that barely existed in China a decade ago.
Market value has soared for certain sectors in China
Thomsen: What I find to be one of the most attractive aspects of investing in China is the ability of companies to scale up quickly. This is hard to find anywhere else in the world. We’ve seen it happen with companies that have strong managements focused on serving a market niche.
Two prominent examples are Meituan, which offers food delivery services, and Pinduoduo, an e-commerce firm that caters to consumers in smaller cities. Remarkably, both companies reached a market capitalization of $200 billion within 30 months of their initial public offerings.
Tech-related companies in China have grown rapidly after IPOs
In the internet space, Alibaba and Tencent initially emulated U.S. businesses but have since evolved into sophisticated multifaceted platforms. But today they might be viewed as the first generation of Chinese internet companies. A new wave of innovative second- and third-generation companies run by dynamic entrepreneurs has emerged. These firms are focused on short-form video, gaming, group purchasing and consumer services.
Kent Chan: The development of the economy, a sizable entrepreneurial business community and wealth creation through investing have created a domestic economy and a burgeoning middle class of over 400 million people that did not exist 20 years ago. And they want better things in life. This has nothing to do with trade tensions or geopolitical uncertainties. It’s just everyday average people looking to have experiences and partake in the consumer economy.
This is creating opportunities for a wide range of companies, both domestic and global. Given the sheer size of the population, domestic consumer brands don’t necessarily have to target consumers outside China to become successful, as Chinese consumers are buying their first homes, refrigerators and other household appliances to improve their living standards. Increasingly, I’ve been seeing domestic companies shift their target end market to local consumers.
One example is the automobile industry. China has become the world’s largest market for autos. Even as marquee brands like BMW and Volkswagen have garnered huge market share over the last decade, five domestic Chinese automakers rank among the 20 largest in the world. China is pushing to be the leader in the electric vehicle (EV) market and EV battery technology. This is an example of where the competition between the U.S. and China can help lead to better innovation.
While Tesla has found some early success in China, the competition in the EV market is rising as local research and development accelerates and more new brands are introduced. For instance, our industry specialist in Shanghai has found that the pace of innovation is making it hard for German automakers to keep up, especially as Chinese consumers are putting more emphasis on the vehicle’s looks and in-car experience. EV newcomer Nio completed its IPO in 2018 and has grown to become the 11th largest car company in the world.
Five of China’s car makers are among Top 20 worldwide
Lovelace: With some uncertainty arising from the political tensions, it’s going to be a challenging period. But it’s important for investors to have a deliberate approach and take control of their strategy. China’s representation in major equity and bond indices is likely to increase over time as China becomes a bigger part of the global economy and its domestic companies grow larger.
I think China is going to be a market for classic stock pickers for quite some time.
Full access to China would create the world’s 2nd largest investable market
Most investors are currently getting exposure to China in their portfolios either through an active strategy or a passively managed index fund that holds companies that get revenue from China. One challenge with owning an index fund can be exposure to state-run companies, an area of the market that we largely find less attractive.
Investing in China involves greater risks, so we believe it’s important to invest on a company-by-company basis to gain an appropriate comfort level. There is a wide disparity in terms of the quality of companies and their management teams. There are also accounting risks. The government has control of the auditing process, but I think top officials understand that it is necessary to have credible accounting practices in order to expand their capital markets.
Historically, we found that one of the better ways to get China exposure and not worry about accounting fraud and corporate governance issues was through investing in multinationals. This used to be an effective approach to access areas like technology, pharmaceuticals and consumer products, where China-based companies either weren’t competitive or weren’t easy to invest in.
But that’s changed over time with the development of several industries in China, including areas of technology, health care and consumer staples. If we find a great company in China, it might be listed in the U.S., it might be listed in Hong Kong or it might be listed on a domestic A-share exchange. There will always be reasons to be cautious, whether that is different accounting standards or trade tensions. However, the size of the market and the progress companies are making mean the investment opportunities are too compelling to ignore.
Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries. Small-company stocks entail additional risks, and they can fluctuate in price more than larger company stocks.
Investing in developing markets may be subject to additional risks, such as significant currency and price fluctuations, political instability, differing securities regulations and periods of illiquidity. Investments in developing markets have been more volatile than investments in developed markets, reflecting the greater uncertainties of investing in less-established economies. Individuals investing in developing markets should have a long-term perspective and be able to tolerate potentially sharp declines in the value of their investments.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
The MSCI China IMI captures large-, mid- and small-cap representation of approximately 99% of the investable equity universe for mainland China's market. There are 945 constituents as of March 31, 2021.
The MSCI China All Shares Investable Market Index (IMI) captures large, mid and small-cap representation across China A shares, B shares, H shares, red chips and P chips. The index aims to reflect the opportunity set of China share classes listed in Hong Kong, Shanghai and Shenzhen.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.
All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.
Use of this website is intended for U.S. residents only.
American Funds Distributors, Inc., member FINRA.
This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.