China: Geopolitical risk and your portfolio

Kevin Cousins

Global investors are increasingly avoiding Chinese equities and according to Bank of America’s September Global Fund Manager Survey, “short China equities” ranks as the second most crowded trade after “long Magnificent 7 stocks.”

While emerging markets (EMs) have been deeply out of favour for many years, a dramatic rotation away from China has occurred within this asset class.

Despite this rotation, China still makes up about 25% of the MSCI EM Index and Taiwan 17%, meaning that at least 42% of the index is directly exposed to Chinese geopolitical risk.

Unpacking China risk
The Chinese economy and markets have been under severe pressure as its policymakers restrict the supply of credit to the property sector. Chinese authorities have also cracked down on sectors such as for-profit education stocks and the internet giants.

Their strict Covid lockdowns, which extended until late 2022, have furthermore severely damaged consumer confidence.

Bloomberg data shows the Shanghai Index has delivered total USD returns of only 6.5% p.a. over the past five years (nearly 80% of which came in the past month after policymakers announced a stimulus programme). On a relative basis, things look even worse. Over the same period, the S&P 500 Index delivered 16% p.a., driven by the Magnificent 7 stocks, which delivered an incredible 47% p.a.

This combination of a very weak economy, extreme pessimism and low stock prices could indicate a very attractive investment entry point. Many high-quality Chinese companies have wide margins of safety that could compensate investors for these risks.

Chinese policymakers also appear increasingly concerned about growth and are reportedly considering fiscal stimulus targeted at households—a potential first. Any measure that counters the deeply bearish consensus could trigger significant market reactions, as evidenced by the Shanghai Index’s 20% surge in just five trading days at the end of September.

Can you mitigate geopolitical risk?
Carefully selected Chinese stocks could be seen as “quality on sale,” with current prices offering compensation for typical economic and jurisdictional risks. The bigger question, however, is how to account for geopolitical risk.

Most assets are held in benchmark-driven mandates that closely track indices, making it challenging to mitigate Chinese geopolitical risk effectively. As mentioned earlier, China accounts for about 25% of the MSCI EM Index. An EM manager reducing exposure to 20% may consider this “underweight” China. However, the client would still face significant exposure, with 20% of their capital at risk and potentially subject to substantial loss.

China exposure is not just from Chinese equities
The risk of a China-Taiwan conflict extends beyond Chinese equities. Taiwan represents 18% of the MSCI EM Index and 25% of the MSCI EM ex China Index, making it a key component of emerging market portfolios. For instance, the MSCI EM ex China Index ETF allocates 25% to Taiwan, with Taiwan Semiconductor Manufacturing Company (TSMC), the world’s leading semiconductor foundry, as its largest position at 13.5% of the fund.

Despite being labelled an ex-China ETF, a substantial portion of its assets remain exposed to Chinese geopolitical risk. Unlike many Chinese stocks, TSMC offers little risk premium, with its valuation climbing from a 12x P/E in 2022 to 28.6x, near its all-time high, driven by AI demand. With the majority of its facilities in Taiwan, a China-Taiwan conflict would represent an existential threat to the company.

Hidden China exposure where you least expect it
Two of the Magnificent 7 stocks, Apple and Nvidia, are currently the largest components in the S&P 500 Index, with weightings of 7.1% and 6.6% respectively.

Apple’s exposure to China is notable: China accounted for 19% of Apple’s revenue in the fiscal year ending September 2023, and 26.5% of its operating profit. But exposure isn’t only downstream, it’s also upstream in the supply chain.

About 90% of Apple’s advanced node chips, essential to its devices, are produced by TSMC in Taiwan. Suppliers from China and Taiwan collectively represent over 76% of Apple’s cost of goods sold (Bloomberg Supply Chain Analysis). This significant reliance on Chinese and Taiwanese suppliers deeply integrates Apple’s supply chain within the region. While Apple’s robust balance sheet and 22% revenue from services offer some resilience, it’s estimated that product sales, which constitute 78% of revenue, could decline by 80-90% if access to this supply chain were disrupted for an extended period.

Nvidia’s China exposure is equally, if not more, precarious. In its fiscal year ending January 2024, 39% of Nvidia’s sales came from China and Taiwan. Its upstream risk surpasses Apple’s, with over 90% of its chips manufactured in Taiwan and no significant services segment to offset potential disruptions. A Chinese invasion or prolonged blockade would pose an existential threat to Nvidia’s operations.

The index itself can be risky
Most investors perceive benchmark indices as “low-risk” portfolios, assuming risk arises only from deviating from them. However, this depends on the index being well-diversified, which isn’t always the case. When indices become heavily concentrated in a few sectors or stocks, this assumption breaks down. Many overlook how index composition can shift over time. Even the S&P 500, a key global benchmark, has seen periods of over-concentration in highly overvalued stocks, as it does today.

In such conditions, sticking to the benchmark can expose investors to significant risks, despite what conventional risk metrics suggest.

Despite these challenges and pitfalls, we don’t view Chinese stocks as uninvestable, but we demand substantial compensation for the risks and continue to closely monitor our overall exposure.