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  1. Home
  2. / Investing
  3. / Stocks

A Slowdown in China Is Bad News for Global Equity Bulls

With MSCI increasing the weight of domestic Chinese stocks in its global index weighting, what happens in China does not stay in China.
By JIM COLLINS
May 17, 2019 | 09:00 AM EDT
Stocks quotes in this article: NIO, TCEHY, IQ, WB, BIDU, BABA

In my Real Money column last Friday, I mentioned four Chinese stocks -- Tencent (TCEHY) , iQiyi (IQ) , CATL and NIO (NIO) -- that I would buy if the Chinese stock markets cratered owing to trade war concerns. The Shanghai Composite is having a rough day Friday, down more than 2% as of this writing, but will actually finish the week just a few ticks below where it finished last Friday. The Composite is still more than 20% above its December lows -- even in the face of trade jitters -- so I am not adding Chinese stocks to my clients' portfolios just yet.

Interestingly, though, the comparisons I made in the last paragraph are somewhat apples-to-oranges, as none of the four stocks I mentioned are in the Shanghai Composite. Tencent trades in Hong Kong, CATL in Shenzhen and NIO and iQiyi on the New York Stock Exchange. That's a key point to note here. When U.S. investors think of "China Inc.," they tend to think of Jack Ma's Alibaba (BABA) , search engine giant Baidu (BIDU) or social network Weibo (WB) , but, again, those stocks trade on U.S. exchanges, not Shanghai's big board.

This is becoming more relevant for global investors, as MSCI will quadruple the weight of domestically-listed China "A shares" to 3.3% of its global index weighting by the end of the year. Those indexes already hold Alibaba and Tencent -- owing to those companies' relatively large size in foreign markets, so what is being added? A bunch of Chinese financial companies that you probably have never heard of.

A quick check of the composition of the Shanghai Stock Exchange's Shanghai 50 blue-chip index shows a heavy weighting toward financials. In fact, 60.5% of the SSE 50's current volume is composed of financials, led by insurance giant Ping An, which represents a massive 16.8% of that index's composition.

I spend more time researching China than most of the talking heads I hear bloviating about the Middle Kingdom on CNBC, but I had never heard of several of the financials in the SSE 50's top ten, nor the lone industrial component, Inner Mongolia Yili Industrial Corp. I am sure a dairy company headquartered in Hohhot, China, is real hotbed of activity on a Friday afternoon, but, as much as I love due diligence, I have no desire to head to Inner Mongolia and watch cows being milked.

So, let's not forget that China is still a developing market. A heavy weighting toward financials is commonplace in emerging markets, as regulators tend to dictate a healthy portion of equity among banks' capital bases. Those banks' ability to earn a return on that capital is dependent on systemic financial conditions, of course. Just as the Fed calls the tune here in the U.S., the People's Bank of China keeps a tight rein on the money supply in that country.

As difficult as it is to "Fed-watch," gauging the PBOC's actions is nearly impossible owing to frequently contradictory moves. For instance, in April the PBOC removed liquidity from the economy via non-replacement of medium-term lending facilities while at same time cutting reserve ratio requirements for small banks, which is, of course, liquidity-positive.

It is undeniable that the underpinnings of China's financial system -- I get my data here from ace China-watcher Andrew Hunt of Andrew Hunt Economics -- have weakened in the past six months. This is shown in a pronounced slowdown in fixed asset investment and a decline in both current account balance and budget balance. Also, sales in the auto industry -- my old bailiwick -- have plunged dramatically this year, including a 17% decline in April.

What does that mean for China's banks, and, by extension, the Shanghai Composite? I don't think the PBOC is going to cut the liquidity spigot in the midst of a trade tussle, but if that implicit backstop is removed at all, I believe there is massive downside for China's economy. That would be manifested among the banks before it would hit consumer gadget and app companies like Alibaba, Baidu and Tencent, but given China's increased weighting in global equity indexes, such a slowdown would not be good for equity bulls anywhere.

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At the time of publication, Collins had no positions in any of the securities mentioned.

TAGS: Emerging Markets | Funds | Index Funds | Indexes | Investing | Stocks | Trading | World | Global Equity

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