Is China’s bear market a major threat to your portfolio?

Chinese stocks are in a full-blown bear market

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It’s time we took a long-overdue closer look at China.

As my colleague Dominic noted yesterday, most global stockmarkets are looking a bit sea-sick at the moment.

However, Chinese stocks are by far the worst– they’re now in a full-blown bear market (in other words, they’ve fallen by more than 20% from their most recent peak).

So what’s the problem? And how much of a knock-on effect might it have?

China is huge, but investors blow hot and cold on it

China is fascinating. It’s a huge and increasingly important global political power; it’s a huge and increasingly important economic power; it’s a huge and increasingly important military power – yet it seems to drift on and off investors’ radar.

That’s partly because, even although everyone has been talking about China for years, it’s still not a market that most investors in the UK would explicitly allocate money to.

I imagine that quite a few of you own some Chinese stocks, but that they are mostly within funds that own a lot of other stuff too. So you might own Tencent and Baidu because you own the Scottish Mortgage investment trust. Or you might own Chinese stocks as part of a wider emerging-markets tracker fund.

But you probably don’t think “I must have x% of my money in China” in the same way that you might think “I must have x% of my money in the US”.

And that’s entirely understandable. China might be a huge and growing economy, but it’s not terribly transparent. It’s hard to know exactly what’s going on over there. You can’t have faith that property rights are watertight. Corporate governance is ropey at best.

MSCI – the influential market index provider – has only just started to include Chinese A-shares in its emerging-market benchmark index. (A-shares are the ones that trade on the Chinese mainland stock exchanges, the Shanghai Composite and the more tech-focused Shenzhen stock exchange). And the index provider is taking the process very slowly.

As the FT’s Emma Dunkley and James Kynge put it in a piece last month, “by objective measurable standards, A-shares are among the most highly-leveraged, volatile, worst governed and most heavily-diluted cohort of shares in any emerging market.” In short, even your average Aim investor might be shocked at the standards on display.

In short, there are lots of good reasons why China doesn’t loom larger than it does in the typical Western investor’s psyche.

Trouble is, while China might be of interest only to the more adventurous investor on the way up, when it runs into trouble on the way down, everybody needs to prick up their ears. And that’s what seems to be happening now.

What’s at the heart of China’s woes?

Not only has the Chinese stockmarket fallen hard, the Chinese currency – the yuan – has been sliding sharply over the last few days. You might remember that something similar happened in the latter half of 2015, and it led to a panic in stockmarkets across the world.

So could we see that again?

As the FT points out, it’s easy to blame China’s market woes on trade tensions with the US. But there’s a lot more to it than that.

China is still engaged in its endless juggling act of trying to maintain a centralised authoritarian leadership, while also allowing enough of a market-based system to encourage continuing economic growth. That’s not an easy thing to do.

Right now, China is trying to tidy up its financial system in order to avoid a financial crisis. And little wonder.

Bloomberg reports that a think tank backed by the Chinese government (the National Institution for Finance and Development) has very recently warned that “China is currently very likely to see a financial panic. Preventing its occurrence and spread should be the top priority for our financial and macroeconomic regulators over the next few years.”

This, for example, is why China is cracking down on “shadow banking” (basically, companies raising money via non-bank channels or off-balance sheet, often by borrowing money from savers who believe– often wrongly– that there’s some sort of implicit government-guaranteed return involved).

That in turn is one reason why the number of defaults on Chinese corporate bonds has risen this year (which is a good thing – functional markets require the possibility of bankruptcy and loss).

Meanwhile, reports on the economy are mixed, depending on which statistics you use. There’s nothing to suggest that the situation is desperate. But with credit conditions tightening, the obvious concern is that growth is squeezed too.

Then of course, there’s the whole story about the A-shares being added to the MSCI index. That drew in a lot of speculative money ahead of time, because everyone knows that when stocks are added to important benchmarks, a lot of money is effectively forced to flow into them.

But this is also a “buy the rumour, sell the news” situation. As a report from Research Affiliates (which I cover in the latest issue of MoneyWeek magazine, out tomorrow – Sign up here if you’re not already a subscriber) notes, when individual companies in the US are promoted to the S&P 500 index, they tend to outperform ahead of promotion, but then spend about a year giving all of that outperformance back.

In the case of China, it’s quite possible that investors simply got overly-excited in the run-up to its promotion into the big indices.

In short, there are a lot of reasons for the wobbles in the Chinese market right now. But there is no single killer reason to say either “sell” or “buy”.

Indeed, if I’m honest, looking at the market right now, I’m more inclined to keep an eye out for a buying opportunity, rather than worry about a pending crisis.

To be clear, I’m not buying yet – I feel that would be foolhardy, given the sturdy dollar and the range of mistakes that could be made over the trade disputes. But it’s definitely on my watchlist, particularly if it keeps getting cheaper from here.

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