China’s economic growth over the past two decades has been phenomenal: its rising power and significance have had a substantial impact on asset prices, and will influence global investment decisions even more in the future; its capital markets have seen continued growth; and its wealth and asset management industry are developing fast, making the country an important consideration in any investment strategy. China’s impact on the investment scene has become too large to ignore. 

For this reason, the Institutional Asset Management Committee of CFA Society Toronto held a webinar on June 15, 2020, hosting an expert panel on this exact topic. The panel consisted of the Hon. John McCallum (former cabinet minister and Canadian ambassador to China, and currently a senior strategic advisor at McMillan LLP), Prof. Gordon Houlden (a political science professor and director of the China Institute at the University of Alberta, and adjunct professor at the Alberta School of Business) and Barry McInerney, CFA (president and CEO at Mackenzie Investments). The panel was moderated by Tania Lai, CFA (managing director of public equities at IMCO).

Three broad themes about investment strategy emerged from the discussion: that it is important to stay cognisant of the fluid relationship between the U.S. and China and its impact on the global supply chain; that Canada is caught up in the deteriorating diplomatic relations of these two economic giants, which will require careful navigation; and there is a growing case to be made to consider a specific asset allocation to China in any global investment strategy. 

Although the impact of COVID-19 was discussed, it became clear that, when thinking about China as part of your investment strategy, the time horizon under discussion stretches well beyond the period of economic impact by COVID-19. 

U.S.-China diplomatic relations and their influence on the global supply chain

Trade and diplomatic relations between the U.S. and China have deteriorated over the past three years, which is likely to have an important and lasting impact on the global supply chain. The COVID-19 pandemic has already highlighted how vulnerable production can be to unexpected interruption. Additional disruptions to the global supply chain could result from an intentional U.S. government policy that aims to decouple from China and shift production elsewhere, or simply because large corporates may decide to manage their production and operational risk proactively in the event of future supply disruptions. 

That said, unlike during the Cold War, where economic ties between the West and the U.S.S.R. were extremely limited, global trade between most countries and China is now highly integrated. This is the case even more so for the U.S., and as a result, a complete decoupling of the supply chain is neither economically feasible or likely. In fact, the integrated trade ties between the U.S. and China, and the dependency of both economies on this trade, serves as a brake in the rising political rhetoric. A side-effect of a large decoupling between the U.S. and China could ultimately be increased political tension, rather than less. 

The speed at which potential decoupling might take place is also an important consideration. As China moves up the development chain, there is a natural rate at which manufacturing and the supply chain will migrate away from China towards other countries—most likely elsewhere in Asia—where wages and costs are lower. This migration should see Asia maintain its status as the growth engine for the global economy. 

Government policies can change much faster than this natural rate of migration in production. And, while policy can move quickly, supply chains cannot—the scale, skills, and infrastructure needed do not exist in many of these potential new manufacturing locations. A fast and deep decoupling of trade between the U.S. and China would see the U.S. and other countries face supply shortages and higher prices, which in turn would hinder any economic recovery.

China is also vulnerable to disruption in the global supply chain—even more so than the U.S. The U.S. is, to a large extent, a self-sustainable economy when it comes to demand, while the Chinese economy remains supply-side driven and highly dependent on foreign demand. The consumer constitutes ~40 percent of the Chinese economy, compared to ~70 percent in the U.S. Over time, however, the rebalancing of the Chinese economy away from investment towards consumption should make the country more self-reliant when it comes to demand. 

Is Canada caught in an impossible triangle? 

Canada has the opportunity to build strong economic relations with the two economic giants of the world, the U.S. and China. If Canada can continue to have strong relations with both these economies, that would be first prize. 

Canada is also exposed to tensions between the two economic giants and may well become caught between them as political tensions rise. We are already beginning to see signs that, as the relationship between China and the U.S. deteriorates, Canada will be forced to choose sides on many issues, especially trade. The pressure from Washington on Ottawa will become greater, and Canada could be forced to compromise on many fronts to manage bilateral diplomatic relations. It goes without saying that the better relations are between the U.S. and China, the better it is for Canada. 

China deserves a specific portfolio allocation

China’s economy, despite any geopolitical tensions, is growing at a fast pace, and China’s stock and bond markets have become the second largest in the world, despite its asset management industry being only ~20 years old. Furthermore, the country boasts a high savings rate, giving the pension fund, wealth, and asset management sector substantial room in which to grow. This situation fits neatly into the Chinese government’s strategy of developing a fully fledged financial industry. 

The supply of stocks and bonds in China is set to accelerate as the government steers domestic financing away from financing via state-owned entities and towards the capital markets. Currently, less than 20 percent of corporate financing needs are done through the local capital markets, while this number is closer to 80 percent in the U.S. Funding through the local capital markets in China should gain traction, and there is likely to be no shortage of supply. Regulations are slowly being relaxed to allow for greater participation by foreign firms in the domestic capital markets, which is likely to provide increased comfort to foreign investors when allocating assets to China.

These developments provide a long-term opportunity beyond the current economic headwinds and short-term political noise. China separates itself from the U.S. and Canada by having a low correlation with domestic capital markets, and separates itself from other emerging markets not only in correlation but also in size. As a result, a strong case can be made that the country deserves a specific asset allocation in any global portfolio, above and beyond any existing emerging markets exposure. 

Only time will tell for the future of their burgeoning financial growth.