U.S.-China tensions over international trade have steadily deteriorated in the past couple of years, with the latest headlines pointing to fresh efforts to decouple the two largest economies in the world.
The latest concern is talk of capping the flow of U.S. capital into Chinese companies which comes at a precarious time for investors who are banking on the success of trade negotiations this week in Washington D.C.
Société Générale analysts say continued discussions of measures to limit U.S. investments in China could upend the impressive performance of its onshore stock-market this year.
“Broadly speaking, we can define three stages in the rising economic tensions between the two countries,” Société Générale argued in a note Tuesday. “The first stage started with the tariffs dispute and is ongoing. The second stage extends the conflict to China investment to the US (CFIUS) and export controls (through the Export Control Act and the Entity List). The third stage might involve restrictions on US capital funding Chinese firms. It has not started but that is a risk that we have advised to hedge,” they said.
It’s the third step that represents the “worst-case scenario” for Chinese equities, said the Société Générale analysts, adding that such measures could include preventing U.S.-based stock index providers from putting Chinese stocks in benchmarks pegged to trillions of dollars of assets.
Still, they still favored keeping Chinese stocks in portfolios if only because legal difficulties and recent denials by the U.S. of plans to delist Chinese companies had made more draconian measures to curtail U.S. capital flows unlikely to take place.
China’s CSI 300 stock index is up 27%, compared with the 16% gain in the S&P 500 SPX, -0.90% , FactSet data show.
Bloomberg News reported White House officials had narrowed down its menu of policy measures used to restrict U.S. investments into China, specifically removing certain Chinese stocks from government pension funds.
But in the event of a broader “assault,” analysts at the French bank say it could undermine the case for holding Chinese equities for three reasons:
One, Chinese efforts to lower debt levels in the economy depend on a backdrop of rising domestic equity values. Policies to allow private investors to take stakes in state-controlled companies will only see uptake if they anticipate values of their investments rising.
“If debt/equity ratios cannot be curbed by raising the denominator, the overall debt de-leveraging process will become more painful,” they said.
Further attempts to prevent U.S. and overseas investors from accessing Chinese capital markets could raise the risk premium of the country’s equities, which has gradually shrunk in recent years as its stock markets become more accessible. The risk premium denotes how much investors demand in additional returns for holding stocks over risk-free assets like bonds.
“Questioning China equity integration in global financial markets would increase the risk perception,” said Société Générale.
Chinese risk premiums have fallen
Finally, restricted inflows into Chinese markets would undermine arguments by bullish investors who saw the opening of the country’s domestic equities to overseas investments as a catalyst for further gains. Under pressure to match their competing benchmarks, money managers would increase their allocations to Chinese equities.
They point to MSCI’s decision to include onshore Chinese stocks in a wider range of indexes last year, a move that comes as Beijing removes restrictions on Wall Street firms from buying and selling Chinese assets.
Société Générale estimated that onshore markets have attracted between $50 to $60 billion since the index provider first included domestic listed A-shares in its benchmarks in 2018.
Foreign holdings of stocks listed in Shanghai and Shenzhen’s bourses stood at around 3% in June 2019, more than doubling since 2016.