Notes from the Kitchen

The Manchurian Candidate

  • Aug 25, 2021
  • Mark Clubb

(Cover Image Source: Artsy Vibes)

For younger readers, The Manchurian Candidate is a novel by Richard Condon, first published in 1959 and later in 1962 made into a film.

The basic plot is Soviet and Chinese soldiers capture a U.S. Army platoon during the Korean War, and take the men to Manchuria in communist China. One of the men, Shaw, is part of a prominent American political family. Shaw is brainwashed by communists and then returns to civilian life in the United States, where he becomes an unwitting assassin in an international communist conspiracy to subvert and overthrow the U.S. government.

Over the last five years, there may have been no bigger hype than investment in China and for good solid economic reason. For example, the estimated population of 1.44 billion people, about four times the size of the U.S. population with its rising middle class. All those new consumers buying Western brands; Nike, Apple, Tesla, Gucci, etc.

Let’s remember It is the world’s second-largest economy, and economists forecast it’s poised to overtake the U.S. economy in scale by the end of the decade.

Then there was the massive technology opportunity, capability with industry players such as Alibaba with its e-commerce platform to rival Amazon. China has tech giants like Tencent and JD. com equivalent to the best of Silicon Valley.

Today China’s stock markets are under pressure from the widening Chinese Communist Party’s regulatory crackdown.

China has not been kind to investors this year.

Newspapers, including the Financial Times are writing almost daily about China Tech stocks being thumped; most recently, it’s a new data privacy law that’s caused the big names to spiral down another 5%. Many portfolios are suffering. Alibaba is down 48% while Tencent is 44% lower. China focused funds are doing equally badly.

Many long-term China bulls have referenced how China is still only 3% of global investment portfolios, but 14% of global market cap, and even well-known investors like Ray Dalio of Bridgewater have favoured China.

Bulls compared the investment merits of the East versus the West. Trump had made it the U.S. versus China. Was Trump our unwitting Manchurian Candidate?

Bulls expected China would continue its appeal to western investors, encouraging them to invest into China with China having better long-term valuation and demographic metrics than the overpriced US market and stagnant European stocks.

What happened?

Back in January this year, Alibaba was amongst the 10 largest companies on the New York Stock Exchange by market capitalization, with a value of $591.59 billion. That is bigger than Berkshire Hathaway, JPMorgan Chase, Visa, and Johnson & Johnson.

But Alibaba’s share price has been in retreat since last October, following widespread reports that Alibaba founder Jack Ma had mysteriously disappeared from public view. His ‘disappearance’ lasted for three months, with speculation rife regarding his wellbeing and safety.

Today, the market capitalization sits at roughly $ 423 billion, and the stock remains in a free fall (bounded 10% today).

Ma is a member of the Chinese Communist Party. He is worth billions. But he dared to revolutionize banking through a company called Ant Group. In October 2020, Ant Group — an offshoot of Alibaba was preparing to IPO. He gave a speech that criticized the nation’s banking system. The comments reportedly reached President Xi. It didn’t go over well with leadership.., and the Ant Group IPO was subsequently canceled by the government.

Then in April 2021, Alibaba was fined a record $2.8 billion after an antitrust probe found it had abused its market dominance; the message and direction of travel from the CCP was, and is, clear. We have had a succession of clampdowns on “regulatory grounds” making the whole Chinese stock market increasingly unfriendly, undermining investor confidence in Chinese consumer tech stocks.

Online shopping platform and delivery service Meituan's plunged 40% as Beijing "improved" standards for food delivery workers with a set of new burdensome regulations.

Tencent was hit by Beijing's recent order, citing competition concerns, to scrap its plan to acquire music streaming player China Music Corp.

Next, Beijing enshrined new rules that eliminate for-profit tutoring, a move that forces some private sector schooling or learning companies to become nonprofits.

Shares of education stocks Gaotu Techedu (GOTU), TAL Education Group (TAL), and New Oriental Education & Technology Group (EDU) are all off more than 80% from their 52-week highs.

Despite these acts committed investors in China saw this as a slap on the hand and warning to other billionaire technology company founders and major shareholders. However, there was confidence China and President Xi would resume the visage of an investor friendly country.

Those continuing to be positive argued that the soft adoption of “capitalism” had been a driver of the Chinese economy over the last few decades and the Communist Party would not risk killing the golden goose.

The Chinese government has even issued reports suggesting that the concerns about this crackdown are overblown.

But if we follow the institutional investors, we’re seeing massive outflows from the market. If this continues, it will be very difficult for the Chinese government to attract investment.

Alibaba appears to be the biggest victim of this crackdown. And despite the company’s huge potential and massive consumer base, investors have chosen to stand on the sideline.

The Chinese State is justifying its actions claiming it is imposing market discipline, regulatory oversight, customer protection, but you could view it as the Party imposing its will on the economy directly by managing entrepreneurs and reminding them whose interests they would do well to serve. Not dissimilar to the experience in Russia.

This has made the whole Chinese stock market increasingly unfriendly. At the time of writing, MSCI¬ China¬ has fallen¬ by ¬29% ¬since¬ the February 17 record¬ closing high.

It has wiped hundreds of billions from the index market value and wreaked havoc for investors holding portfolios or funds and ETFs with heavy Chinese tech exposure, which seemed like such a clever “no brainer” just a few months ago.

We have, and are seeing, massive institutional investor outflows from the market. If this continues, it will be very difficult for the Chinese government to attract investment.

Alibaba appears to be the biggest victim of this crackdown. And, despite the company’s huge potential and massive consumer base, investors have deserted the shares or remain for now on the sideline.

Hindsight is a wonderful thing. Before all this “self-harm”, warning signs were there coming from a different direction.

You may recall Mr. Trump, late in his office, expressed a desire to delist certain Chinese stocks from U.S. exchanges.

Earlier this year, the Holding Foreign Companies Accountable Act, which the Trump administration championed, became law. That gives the U.S. Securities and Exchange Commission (SEC) the ability to stop the trading of companies that are owned or controlled by foreign governments and run contrary to the new rules of conforming to American accounting and disclosure standards. For existing listed Chinese companies this is virtually impossible for them to do without breaking legal requirements in China.

The consequence is that all US listed Chinese companies will need to delist in America sooner or later; and relist in Hong Kong and/or China. So far 14 have already done secondary listings in Hong Kong with many more expected to follow.

Let us also remember that Trump initiated the "tariff war" with China, targeting everything from solar panels to steel, as part of his effort to reduce the U.S. trade deficit.

The U.S. and other Western nations accused Huawei and ZTE of being national security risks on the assumption they were conducting espionage on behalf of the Chinese government.

The result being both companies being banished out of the 5G network procurement contracts.

We had the U.S. presidential order barring U.S. companies and individuals from investing in firms that the administration alleges aid the Chinese military.

In June, the U.S. Senate passed legislation to counter China's growing influence by investing more than $200 billion in technology, science, and research.

In a partial response, Beijing has announced plans to tighten restrictions on overseas listings of Chinese companies. For example, the Cyberspace Administration of China announced on 10 July that companies holding data on more than 1m users must now pass a cybersecurity review before seeking overseas listings. The PBOC also issued a statement last Friday that non-bank payment firms, such as Alipay, must report both domestic and overseas listing plans.

Beijing's crackdown on its own tech industry and these developing tensions between China and the West clearly adds risk to investing in Chinese companies.

Geopolitical observers believe Xi is using the clampdown to stop the tech billionaires funding internal political opposition within the party.

What is clear is that China rather than being a capitalist state with communist characteristics, China is looking increasing totalitarian again.

This has always been the risk when it comes to investing in pseudo-capitalist nations, or for that matter Emerging Economies and Developing Markets.

It’s difficult to remain enthusiastic when China is clearly an economy focused on serving the state first, and shareholders a very distant second.

What now?

As investors fret about crashing China stocks, rising global uncertainty and the destabilisation caused by the Afghan debacle, I believe the Chinese are likely to up the pressure and further test a distracted US administration.

The Chinese government is worried about competition. At a time when the communist government is looking to expand its influence if not control, across the world, it remains worried about companies that rival its power and influence.

It looks at the strength of Amazon, Apple, Facebook, Microsoft and other Silicon Valley giants in the U.S. and the influence the likes of Gates, Bezos, Musk and Zuckerberg have on the White House, and it worries about the influence their “corporate” leaders could have on Chinese society.

Further the State doesn’t want any financial competition. China has already launched the “digital yuan,” indicating that the government wants greater control of the financial ecosystem. This could dramatically impact payment platforms such as Alipay, as the Chinese government looks to grow its market shareof transactions.

There have to be concerns that other “social/consumer” sectors come under impactful negative scrutiny and headwinds. For example, luxury goods and domestic residential property, where there is, selectively, a pricing bubble.

My view is that sectors including consumer staples, renewable energy and all things “green”, together with security, will remain ‘’untouched’’.

Will there be a point in time to once again “buy” China?

Almost certainly, but timing would be guesswork and we shouldn’t rely on guesswork, ever.

Over a longer-term perspective, China will continue to have a role in global equity portfolios.

On a fundamental basis, I would expect many of the Chinese stocks once the darlings of investors such as Alibaba to continue to deliver fabulous growth over the coming years. But company-specific virtues are no match for for what’s going on right now.

Even now, many of these companies are delivering spectacular results.

Recent Alibaba first quarter results showed earnings growth of circa 14.7%, and revenues up 34%. The cloud computing division reported 29% year on year sale increase. They also announced a 50% increased share buyback program of $15 billion.

However, neither the earnings report nor the new share buyback program excited investors or the share price.

What we are witnessing currently is a decoupling of the two capital markets, the U.S. and China. And that may not be over yet.

I would recommend the Financial Times article: “Markets haven’t even begun to reflect China-US decoupling risks” by George Magnus, 21 July 2021.

The U.S. and much of the rest of the world are now engaged in an economic "cold war" with China.

That means billions of dollars to fight that war.

Seismic long term capital movements like this always create new investment trends and big profits for those who pick up on them.

I would recommend the Bloomberg article: “China’s Attacks on Tech Could Lose Cold War II” by Niall Ferguson, 11 July 2021.

Meanwhile, the U.S. stock market continues its upward momentum. Could it be that domestic and global investors will continue to pull out of Chinese shares, favoring the more investor friendly U.S. regime?

U.S. companies are performing well.

We have just had a blockbuster earnings season where, according to FactSet, 87% of S&P 500 companies have beaten second quarter earnings expectations. Analysts expect this trend to continue in the current third quarter.

However, we know the bullish trend is going to slow down and reverse sometime. It has to. That’s how markets work. But for now, it shows no sign of slowing down.

The case for “Buy America” for now has louder resonance than for some time. In a turbulent and uncertain world, then the assets with the greatest safety will remain the liquid US stock market winning the flight to quality argument.

To me that also suggests a robust U.S. dollar.

There’s an old adage: “The Americans will always do the right thing, after first exhausting every other possibility.”

TEAM Asset Management is a trading name of Theta Enhanced Asset Management Limited which is regulated by the Jersey Financial Services Commission.