We’ve recently updated our Asia game theater, and although these changes partly reflect the recent regulatory crackdown in China, our update was independent of recent Chinese equity market volatility. We believe this volatility has been largely idiosyncratic to Chinese capital markets and has been primarily driven by the country’s domestic agenda and the regulations that come with that. In sum, our Asia game theater remains broadly stable with respect to most objectives and influences. In terms of positioning, we remain long of Chinese equities in aggregate, with fundamental valuation serving as the primary driver for a recent increase in broad-based Chinese equities, which added to our existing smaller-cap-oriented (A-share) exposure. But let’s look at some of the factors influencing the changes to this game theater by reviewing some recent and current views on two of the major players in this game—the United States and, of course, China. During the first half of the year, both the United States and China focused on their COVID-19 response and domestic agendas. In the United States, much effort has gone into building out a team for formulating strategy, given the new administration. China’s domestic agenda, meanwhile, has been driving recent market volatility and national security. Looking out to the second half of the year, however, incentives appear to be aligning for increasing rhetoric between the United States and China. That is well in advance of the next election cycle: China’s is still a year off, and the U.S. has midterm elections in the fall of 2022. Yet, despite that, it looks like we will see a continued stalemate on U.S.-China trade tariffs given the primary domestic agenda (responding to COVID and exposed production gaps—supply shortfalls—in critical areas). One spot where headwinds are more likely to persist for the near term is the IT sector, particularly relating to isolation on national security grounds. We believe that has dovetailed into several of China’s most recent regulatory calls. Specifically, where China’s domestic agenda is focused—namely, FinTech, and shadow banking. With data use and security as two themes, we expect continued volatility like we have recently seen with education and education technology segments. The volatility has been focused on the MSCI China Index and large-capitalization names, notably affecting those in the aforementioned segments. Notably, this uncertainty has been bond friendly. We have been long local China government bonds and have taken this opportunity to sell into the strength, And, while we are long Chinese equities, the bulk of this exposure, as mentioned previously, is in small-cap China A-shares (rather than large-cap names or the broader MSCI China Index), a segment of the equity market that’s held up reasonably well in the wake of recent volatility. In addition, where we are long, we are long via total return swaps, so we are earning a spread, which is supportive as well. That covers China, so let’s look at some of the other influences on the game theater. First, U.S. risk tolerance has risen since the start of the year, but remains below where it was a year or two ago, and the U.S.’s primary objective remains the reassurance of its allies that it remains steadfastly in alliance with them. We’ve seen that manifest in a few areas. Earlier, it was in the removal of some tariffs with Europe; more recently, it was in the decision not to impose tariffs on Vietnam after a currency manipulation investigation reached its conclusion. One spot where we are seeing a gradual shift in this game theatre is in India, which has generally been a reluctant coalition partner and primarily engaged on security. However, after withdrawing from the Regional Comprehensive Economic Partnership (RCEP)—a proposed agreement between the member states of Association of Southeast Asian Nations (ASEAN) and its free-trade-agreement partners—there appears to be some groundwork being laid for potential bilateral trade deals with the United Kingdom, Australia, and at some point perhaps even the U.S. and Europe. All things considered, we believe the medium-term influence of the dominant powers is relatively positive for several ASEAN markets and currencies, especially Vietnam. Meanwhile, this influence is relatively negative for Chinese, Taiwanese, and U.S. markets and neutral for Australian, Korean, Japanese, and Indian markets. Horizon is important in this assessment of various regional exposures—they are all medium-term. For the near term, we expect a relatively benign overall backdrop across markets and currencies in the region. Aaron Balsam, CFA, is a senior analyst on William Blair’s Dynamic Allocation Strategies team.
CNY - Chinese Yuan Renminbi