Keeping Clients Calm Amid China Calamity

It's often said that investing in emerging markets carries political risk. Whether it's an election gone haywire in South America, political protests just about anywhere in the developing or myriad other issues, there are reasons emerging markets equities are more volatile than U.S. equivalents.

China is recently upping that ante with Beijing taking an exceptionally heavy-handed approach to the country's internet companies, mobile app purveyors and for-profit tutoring firms, among others. China's renewed penchant for interjecting regulatory risk is dealing blows to stocks previously viewed as the country's most attractive and suitable for long-term investors there and in the U.S.

Obviously, this concerning for clients on multiple levels. The internet stock-heavy NASDAQ Golden Dragon China Index is off nearly 13% over just the past week and even clients aren't holding a dedicated China internet or stocks like Alibaba or Tencent, there's a reasonable chance they still have some China exposure.

For example, the supposedly diverse Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO), the largest, cheapest ETF in this category, holds 5,225 stocks – a whopping 40.2% of which are Chinese companies.

Dark Days Indeed

The tale of the tape, thanks to Beijing, for many previously beloved Chinese stocks is gruesome. Tencent, the country's largest internet company, lost $170 billion in market value this month and there's still Thursday and Friday to get through. Nine of the 10 worst performing global stocks in July are Chinese names, according to Bloomberg data.

Another fun fact: Alibaba, often referred to as the “Amazon of China,” is sporting a share price last seen in 2018, but its sales have quadrupled in that span. Chinese leaders appear to be getting some sense for the havoc they're causing because they convened an emergency meeting late Wednesday with major investment banks and asset managers in effort to calm nerves.

Some analysts see cards for internet companies to play, but with Beijing now in the business of heavy scrutiny, there are risks here as well.

“We believe if major Internet companies announce new share buyback programs or increase size of existing buybacks, it would demonstrate the management’s confidence in fundamentals and reassure investors on profit growth outlook,” said Citigroup analyst Alicia Yap.

At least there's a timeline for when the controversy could end, assuming Beijing honors it.

“The Ministry of Industry and Information Technology (MIIT) announced that a six-month review of internet companies commenced on July 23. The review will encompass cybersecurity, data privacy, consumer protection, and monopolistic behavior,” according to KraneShares, an issuer of multiple China-specific ETFs.

Nearly 70 Chinese internet firms, including including Baidu, Alibaba, Tencent, ByteDance, Sina Weibo, and iQiy have already completed required rectification.

Trying to Get It Right, But...

Some of the aforementioned companies are complying with Beijing. They've got no choice but to do so and those measures are proving punitive.

“Last quarter, Alibaba received a multi-billion dollar fine for anti-competitive practices. Ant Group has already successfully restructured as a financial holding company subject to bank rules,” adds KraneShares. “Meituan is taking steps to ensure its drivers make at least the local minimum wage while improving their training and safety conditions. Tencent has given up exclusive rights to certain content on its music streaming services. Didi, whose rushed IPO cratered post-regulation announcement, likely still faces a steep pending fine.”

As for what sector is next in Beijing's crosshairs, it might be wise to steer clear of Chinese real estate investments for awhile.

Looking further out, China's regulatory crackdown on fintech and internet companies could facilitate more competition and remove systemic risk concerns (fintech), but these potential positives are going to take awhile to play out.

For now, advisors can tell clients to minimize or eliminate China exposure. Or for the risk-tolerant, they can get involved here because history shows every previous sweeping regulatory effort by Beijing ultimately gave way to sizable upside in the targeted sector.

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