China: Looking Past the Headlines

There's been no shortage of China headlines recently, from the currency devaluation that roiled markets in August to the extreme volatility in the onshore stock markets as well as the continued opening up of the market to foreign investors. KraneShares' Brendan Ahern, Dodd Kittsley from Deutsche Asset & Wealth Management, and Morningstar's Dan Rohr spoke at a panel Thursday morning moderated by Morningstar's Jackie Choy at our annual ETF Conference. The panelists discussed what's been driving some of these big moves as well as how it could impact investors.

What's Driving Stock Market Volatility? All three panelists agreed that the big runup and subsequent fall in the Shanghai and Shenzhen markets was not being driven by the underlying economic fundamentals of China. Dan Rohr pointed out that the Chinese economy has been decelerating through the whole period of this volatility and that the trajectory of the decline hasn't changed much either. He sees a change in expectations as the big driver along with the "basic set of animal spirits."

Dodd Kittsley agreed that the market moves were disconnected from fundamentals. He sees the growth of margin accounts in recent years as one of the big drivers of the volatility; but he pointed out that margin trading is now down by two thirds since the peak, which is a healthy thing for the market over time.

Brendan Ahern added that the correlation between all Chinese shares has been very high during the recent sell-off. The market doesn't seem to be differentiating between companies traded in mainland China, those traded in Hong Kong, and Chinese firms listed in New York. This has, in his mind, opened up opportunities to buy some fast-growing consumer-oriented companies that are being unfairly punished right now.

How Badly Is China Slowing? One of the big question marks around China right now is how fast the economy is really growing. All three panelists expect GDP to come down from the 7% levels today, but the composition of that growth was an area of some disagreement. Rohr thinks the downturn will be widespread. He thinks the decline in the investment economy will depress asset prices (most notably real estate) and that this will have a big impact on the consumption-based economy. He doesn't see the Chinese consumer immediately picking up all of the slack created by the slowing investment sector. Kittsley and Ahern were both more optimistic about how consumers will handle the downturn; they say some of the non-GDP metrics paint a more promising picture.

Know What You Own The panel also emphasized that the divide in growth between the investment and consumption economies is an important one for ETF investors. That's because many traditional China indexes have heavy exposure to sectors such as financials and manufacturing that are heavily exposed to the slowing investment sector; at the same time, those indexes have little exposure to the technology and consumer names that are likely to have stronger fundamentals. Before diving into a product, investors need to look carefully at the index--not just at the name of the product--to make sure they are actually getting the exposure they are seeking.

Should You Have China Exposure? So, if the Chinese market has shown itself to be extremely unpredictable, should investors be allocating a slice of their portfolio to it? All the panelists agreed that if you are going to buy China, it has to be a long-term allocation. Rohr thinks that trying to make a short-term bet is akin to putting your money down at a "blackjack table" in which the casino may change the rules of the game on you in the middle of a hand.

Others saw the prospect of investing as more enticing. Kittsley and Ahern both argued that China is just too big to ignore and that slowing GDP growth shouldn't be a deal-killer for investors. They also pointed to a potential tailwind in the coming years for China investors as the country becomes a bigger part of major emerging-markets indexes and opens up its market more to foreigners. Currently, the MSCI Emerging Markets Index is only about 25% China; however, it should be closer to 40% and may go even higher than that if countries such as South Korea and Taiwan are moved out. The amount of money that will move into Chinese shares, along with the country opening up and continuing to liberalize its markets, will have a "profound" impact, according to Kittsley. He added that a more diverse investor base will fundamentally change the capital markets in the country. From a portfolio standpoint, Ahern emphasized that an allocation to China should still remain modest for most investors and that it's sensible to rebalance regularly, given the volatility.