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Politics in China – what it means for investors

Lots of investors and fund managers now consider environmental, social and
governance (ESG) issues as part of their investment process. ESG risks, such
as a company’s water usage, can seem abstract. But that’s not the case in
China today.

Recent political regime developments have accelerated this year’s decline in
Chinese stock markets. But what’s changed and what does it mean for investors?

This article isn’t personal advice. If you’re not sure what’s right for your
circumstances, seek
financial advice.

What’s been happening in China?

The latest downturn in the market was a direct reaction to a change in
governance. In October, president Xi Jingping was appointed for a third term.
This was widely expected by investors.

Xi had been in charge for the last ten years and the markets pretty much knew
he’d be appointed for another five years. This was despite the appointment
breaking a convention in place since the 1980s where leaders should serve a
maximum of two five-year terms.

The surprise came in the reshuffle of the Politburo Standing Committee – the
most powerful political body in China.

For the first time since Deng Xiaoping’s exit from his last official role in
1989, the Politburo is made up entirely of people loyal to the leader. Former
leader Deng set China on the path of economic and political reform in the
1980s. These reforms included a check on the leader’s power, making sure
politicians from all factions of the party were represented in the Politburo.

TV footage of former leader Hu Jintao being led out of the
closing session of the Communist Party Congress made a symbolic illustration
of this shift of power. With no obvious successor among the Politburo members,
many political experts expect Xi to remain in power beyond this five-year
term. China increasingly looks like an autocracy.

Beijing resident Joerg Wuttke, president of the EU Chamber of Commerce in
China said: “We have been used to economic growth, reform and opening up for
almost forty years. China was the world’s economic engine. Now the country
is taking a completely new path.”

What it means for China’s economy and stock market

Investor attitudes to China have already been shifting since the spring with
outflows from Chinese share and bond funds. China continues to claim that
Taiwan is one of its provinces rather than an independent state. Investors are
right to think about what could happen if China decided to take Taiwan by
force, even if this doesn’t appear an imminent threat.

Government policies are now expected to focus more on maintaining political
control. This shift is already affecting investors. Asset manager WisdomTree
has removed tech companies representing more than a quarter of the value of
its China index “due to their involvement in severe violations of freedom of
expression in China”, which makes them “non-compliant with UN principles”,
according to a director at WisdomTree.

China’s economy has been among the fastest growing in the world for the past
three decades. However, the country’s tough stance on COVID shutdowns means
it’s likely to lag the average emerging country this year. And there are no
signs of restrictions being eased any time soon.

What’s more, the outlook is for much slower growth going forward. China has a
shrinking working-age population, a heavy debt burden and declining
productivity growth.

What should investors consider?

The Chinese markets are huge players. They make up the largest part of both
share and bond indices in emerging markets. Hong Kong, Shanghai and Shenzhen
each have more than 2,000 companies listed on their stock exchanges. China’s
bond market is the second largest in the world after the US.

One key difference is the markets are dominated by domestic investors, helping
to explain why its direction doesn’t always move in sync with wider global
markets. This can be good news for investors as it helps to lower the
volatility risk of an
investment portfolio and creates an extra layer of
diversification. This can be
particularly useful during high levels of volatility (market ups and downs).

How to build a portfolio

If you’re investing with ESG risks in mind, it’s important to avoid looking at
China in isolation. It’s true the country lacks the independent institutions
of developed economies, such as an independent central bank. But this is true
of almost all emerging markets – it’s one of the things that defines them.

Why ESG investing matters to everyone

Sustainalytics are a leading provider of ESG risk analysis and publish a
Country Risk Rating for 172 nations. At the end of 2021, China was ranked
67th, lower than Brazil and Mexico but above Thailand, Indonesia and India.
Investing in developing markets adds risk (volatility), so investors are
compensated with a higher expected return than developed markets, although
there are no guarantees.

Another point to consider is valuation. The Chinese market looks ‘cheap’ and
is trading at under ten times forward price-to-earnings (PE) at the end of
September, according to Morgan Stanley Capital International (MSCI), who
publish the widely-used MSCI China index. This is a discount to both the
developed and emerging world averages.

Economic growth is expected to slow, but we still expect the economy to
outpace the world average over the next decade. This provides an environment
for profits to grow too. And the economy should rebound rapidly once the COVID
restrictions are – eventually – lifted. Past performance isn’t a guide to the
future. All investments can fall as well as rise in value, so you could get
back less than you invest.

China offers potential opportunities for investors who have analysed the
changing political landscape and identified companies that can still thrive.
However, in our view, investors are right to exercise caution of Chinese
markets in light of political developments. It’s important for investors to
take a long-term view and diversify.

The Wealth Shortlist has a list of funds selected by our experts for their
long-term performance potential across a range of sectors, including Asia, to
help investors build and maintain a well-balanced and diversified portfolio.

Wealth Shortlist

The Wealth Shortlist is a collection of funds we’ve researched and
chosen for their long-term potential.

View Wealth Shortlist

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