KraneShares’ Ahern Optimistic on China

However, Brendan Ahern, chief investment officer of ETF issuer KraneShares, doesn’t think the situation is as dire as many believe for China. He sees a lot of positive aspects to the Chinese economy as it rebounds, and believes the data supports his thesis.

What’s going on right now in terms of how U.S. investors view China?

There’s the always the apocalyptic view — Thelma and Louise off the cliff. But the reality is China hasn’t had a recession since 1993. So this view of impending doom is kind of interesting. The common narrative would be the Chinese markets haven’t performed well over the last several years or even longer, and this vast underperformance versus U.S. equities is really driven by the fact that they’re communists and we’re free capitalists. That idea is not accurate.

Then what’s really happening? In my opinion, over those 14 years [since the global financial crisis], you’ve had the U.S. market dominated by growth stocks. If you add up all these growth names, [more than 40%] of S&P 500 is growth. But [the U.S. market’s] growth orientation is very different than other benchmarks.

The MSCI Emerging Markets was 50% financials and energy, just like the MSCI China 10 years ago was. Then you throw in industrials, materials, and real estate. These are basically value proxies during a period of growth stock outperformance. If you look at what a growth sector like tech did, the MSCI China Tech index went up 1,651%; more than twice what the S&P 500 did. But that sector was only 2% of the [broad China] index 10 years ago. In emerging markets [overall], tech went up 848% and beat the S&P 500. But it was only 11% of the benchmark. Our brains are wired to find these short-term solutions or these easy answers, [but] it’s more complex.

Would you talk a little more about that?

In my global travels meeting with our client base, I asked, “What does your portfolio look like? What are you overweight in?” And every investor I’ve met with is overweight U.S. equities.

If you think about these numbers, people didn’t really understand how this sector dysfunction was really the culprit for this underperformance. Fourteen years is 56 quarterly client meetings or calls, or 56 investment committee meetings or board of directors or trustee meetings. That’s a long time to defend holding non-U.S. equities — if it’s [broad] emerging markets or if it’s China or if it’s Europe. And [they] slowly cut it down; for many people, it’s fine at zero.

I think this is no different from after the GFC, [when] a lot of U.S. investors gave up on investing in U.S. stocks [after getting whacked repeatedly.] A lot of people just ghahave up on U.S. stocks, and lo and behold, U.S. stocks went on a great epic run [after being] the most hated asset class. Today, you’re in the opposite situation, where U.S. equities are the most crowded trade among investors globally. There’s arguably a lot of headwinds, and I don’t think investors are very well-positioned if there’s a market leadership regime change.

That’s not to say there aren’t issues specific to what’s happened in China, where the economy suffered under the zero COVID policy. The government in the U.S. had a very strong policy response — free money. But now, we’re paying for that with the consequences — high inflation and then the budget deficit. The interest payments on our debt are very significant. The Chinese government is taking a very different and arguably more conservative approach of saying that “we were going to allow the the economy to come back and we’re going to support it, but we’re not going to with the proverbial policy bazooka.”

China as an economy is coming back. The numbers that came out, you know, for September and Q3 beat expectations across the board. But the markets have not reacted. A big part of our thesis is that these nonfundamental factors continue to act as a bit of a headwind, things like the Holding Foreign Companies Accountable Act, ADR delisting, these distressed real estate developers.

There are signs that China has bottomed economically and is improving. We’re constructive [on China], but we realize some of these factors have made it quite difficult. Ultimately, positive price action begets more investor attention. We’re having a lot of interesting conversations with investors about what’s happening. You have a number of government economic meetings on the horizon, so there’s a chance that we will see a little bit more of policy support coming. It’s clear the stock market is aware of how poorly the stock market has done and is trying to kind of jawbone it up.

How big a problem is deflation? It seems to get mentioned a lot in articles about China lately.

Japan has [the same] demographic issue, and there was this balance-sheet recession. China’s going to be in the same boat. It’s kind of funny, I think most people would love to have China’s low deflation. But a lot of countries have a demographic problem. Without immigration, the U.S. has a demographic problem. South Korea actually has the lowest birth rate globally — down to 0.8. But does that mean you wouldn’t hold Samsung stock?

If you’re an export-driven economy, demographics is not a huge problem. But it is a global problem, a developed world problem. China’s low inflation, its CPI, is very much geared to food prices. It’s not calculated the same way ours is, so it’s not really an apples-to-apples comparison. Certainly, the PPI has been quite low. But as some commodity prices have fallen, China’s import of commodities by tonnage has actually stayed very stable. We actually looked at it from a raw tonnage angle.

Do you think China will be less aggressive with its tech sector? It didn’t seem like the actions it took against tech companies were great for its stock market.

Well, the optics around it and the communication were not good. And almost as bad arguably as the regulation itself was how they did it. In September, they said 26% of retail sales occurred online, so that kind of shows that they really do need the key web companies that are integral to the economy. And we think there’s too many signs of actual policy support as opposed to the government being a headwind.

How much of a sticking point is China’s real estate sector given what’s going on with Country Garden and Evergrande?

I think the analogy would be [similar to] when Greece wanted to declare bankruptcy in 2008. The European Central Bank said, “No way.” Because German, French, and Italian banks all hold those Greek Treasuries. It’s a similar situation, I think, for China. You just can’t allow [a Country Garden or an Evergrande] outright to fold, because it’s not just your banks on the hook.

You have people who have a down payment for an apartment or a project that hasn’t been built or at the same time, you have the construction companies that need to get paid. If they don’t get paid, then they can’t pay their employees. That’s why we feel like an outright default, a disorderly default, is unlikely. A restructuring [is more likely]. Certainly the companies will pay for their sins, but a Lehman-like collapse is unlikely.

These Chinese cities, because of urbanization, get bigger and bigger, and then all of a sudden you have property prices decline. And so that’s had a negative impact on that consumer confidence. For the urban households that have upward of two-thirds of their wealth invested in real estate, property decline hurts that consumption story.

It’s kind of multifaceted. But that’s a little bit of why it’s receiving so much attention from the government. We have to be a little careful, because Country Garden could [turn to pudding]. But it’d be kind of out of character — it doesn’t mean that Country Garden and Evergrande don’t have problems or that they’ll go away. They just have to finish what they started.

For more news, information, and analysis, visit the China Insights Channel.