China Contagion?

Michael Rudd, CFA | President, CEO and Portfolio Manager

We have been on a bit of a break from the weekly commentary while we sent out our quarterly and semi-annual fund notes. During that time, there has been some volatility in financial markets. Financial professionals often opine about having assets spread across different asset classes, sectors and geographies in order to benefit from diversification. The theory is, if there is an issue in one area or security type, it will generally be contained to that area and not impact others. However, as time has passed and as we have become more integrated with trade and technology, we anecdotally find that financial assets are becoming more connected, and subsequently more correlated, with one another.

In China, over the recent weeks, there have been some interesting developments, which so far, have had limited impact on other parts of financial markets but we are watching quite closely. A short summary of the issues is below:

  • A Variable Interest Entity (VIE) is a structure that has been in place for years where, through a system of contracts, a Chinese company is able to list its shares on a foreign exchange. This system has recently been challenged by the Chinese government and consequently the US SEC as well. The change will make it harder for foreign capital to invest in Chinese companies. We suspect this is by design as China turns inward for its domestic financial needs.
  • Evergrande Group is the largest property developer in China, with investments in businesses spanning multiple industries. It is also one of the top 10 largest corporate debt holders in the world (USD$100 billion). The company is undergoing a liquidity crisis and its bonds are trading at half of their normal value.
  • Education and Labour Regulations: Similar to the VIE issue, the Chinese government has identified that education and housing costs are too high and general wages are too low to support young people who would like to have families. This is critical to help reverse its long brewing demographic problems. The government views this as a long-term risk and has put regulations in place to reduce educational costs and provide workers with more rights. This has impaired the profitability of the companies that operate in those industries.

“This means that” we believe that in long-term, there are still tremendous opportunities for investing in China but that the government management of essentially all parts of society can causes uncertainty for investors. We also believe that these are short-term issues and that companies will be able to normalize their operations over time to provide substantial value.

Pathfinder Asset Management Ltd. | Equally Invested™
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