The Chinese government is facing pressures on a number of fronts. Its rulers may be about to find out that, for investors, good governance really matters.
We have been negative about the prospects for the Chinese equity markets for some time. We worried about the slowdown in 2019 and the continuing hostility of the US towards the Chinese government over a wide range of issues – from trade through civil liberties to the government of Hong Kong. We thought the strong run-up in shares to April 2019 left the market vulnerable to declines, as prices seemed ahead of growth and profits.
Industrial profits fell in 2019, and the authorities set lower growth targets in recognition of the slowdown. The government and central bank decided they wished to make progress with tackling bad debts and reducing overcapacity in the industrial sectors, whilst hoping new technology and services would keep growth going. We, of course, did not foresee the tragic outbreak of the coronavirus which has come to haunt China this year. That development has highlighted the negatives already facing the Chinese market and has added a new and worrying uncertainty. Share markets are likely to remain under downward pressure until we can see some resolution of this problem.
Governance really matters
Investors today are more interested in governance matters. My colleagues who analyse and comment on individual company shares spend time on studying the ethics and ethos of a company un which they might invest, as that can help forecast how it might behave and how the shares may perform.
It is common now to want a quoted company to have strong governance. This means having a powerful chief executive with an ethical and wise strategy, and a strong chairman who usually supports and mentors the chief executive but who could curb him or dismiss him if things go wrong.
It also requires a strong independent director or two who support both chairman and chief executive, tell them of things miscarrying and who can initiate the removal of the chairman if the company is getting into serious difficulties.
Some of these issues can also be applied to the country’s equity markets in relation to their national governments. Investors are more likely to rate a particular equity market well if they have confidence in the governance of the country, and recognise that it accepts internationally-agreed standards of conduct and ethics. Democratic countries usually have checks and balances in their constitution, and obviously have direct ways of removing bad prime ministers and presidents. Some emerging markets suffer a discount for authoritarian rulers whose judgement can be wayward.
One of the reasons we turned more negative about China was the rising power of President Xi. He has overturned the Chinese system that a President only gets 10 years in office, and is required to identify a successor towards the end of his term. The acceptance that a President will resign limits that person’s power and gives some influence to potential successors. The decision not to have an end date concentrates power greatly in the hands of the current incumbent. There is no directly-elected effective parliament to act as a constraint on the president in the way the US Congress does. There is no independent Supreme Court likely to accept a case against the president and find for his opponents. All is well all the time President Xi makes wise decisions and understands the opposing forces to his policies which exist below the surface, but anything can go wrong as everything depends on his knowledge and judgement.
Openness is key
Some say that the Chinese response to the first outbreak of the new virus in Wuhan was slow. The World Health Organisation (WHO) thinks China is now providing timely information and is co-operating over the outbreak, but there are doubts about how contained the problem is and about those early responses.
The US is raising the issue of the treatment of the Uighur Muslims in Western China, and the handling of the protest movement in Hong Kong. Michael Pompeo, US Secretary of State, recently called for “an immediate end to this repression” of the Muslims. Many airlines have cancelled flights or suspended all services to China. Factories will stay closed for longer as the authorities fight the virus. Western companies dependent on Chinese components and materials are starting to look for alternatives. There will be disruption to the world supply chains, and second thoughts about China as a prime source.
Country governance is likely to become a growing issue as we witness the rise of more ethical investing. China has to show by its response to the triple challenges of the virus, its treatment of religious minorities and its handling of Hong Kong that it understands many investor concerns. If the government is wise, it will adjust to the winds of criticism now coming its way.
For the time being Chinese shares remain subject to many doubts in investors’ minds, particularly in the US where much of the money and opinion-forming rests. There have been recent efforts to provide more liquidity to fragile markets to limit the damage the virus is doing.
The above article was previously published by Charles Stanley on 4th February 2020