China stocks went on a tear in mid-September, gaining about 30 percent by the end of the month, which was enough to goose the third quarter returns of emerging market hedge funds. The big jump came after Sept. 25, when China announced a huge fiscal stimulus package and billionaire investor David Tepper went on CNBC to announce a ‘buy everything’ moment for Chinese stocks.
But don’t get too excited, argued J.P. Morgan Asset Management’s Michael Cembalest, chairman of market and investment strategy. He initially was optimistic about China’s monetary, fiscal, macro, and regulatory reforms, which came on the back of the U.S. Federal Reserve’s 50 basis point cut in interest rates. Cembalest said his enthusiasm was partially driven by “how cheap Chinese equities had become in absolute and relative terms.” But he cautioned, “I see Chinese equities as a ‘trade’ and not an ‘investment,’ partly since China has the worst pass-through from GDP to earnings and equity returns among major markets.”
There is an additional risk to the Chinese market. Cembalest said that there’s a “Thucydides Cap on how high China equity valuations can get,” a reference to the Greek philosopher who argued that war was likely when a rising power threatens an established one. (Cembalest called attention to a 2017 book, “Destined for War: Can America and China Escape the Thucydides Trap?,” by Graham Allison, which found 16 cases over the last 500 years in which a major nation’s rise disrupted the dominant state; 12 ended in war and four did not.)
“This is a movie I have seen before in which China attracts foreign capital just before destroying it,” said the J.P. Morgan strategist.
Cembalest argued in a recent report that “the escalation in Chinese espionage activities in the U.S. may prompt increased sanctions, restrictions and retaliation by both countries.” That could come in the form of “more bilateral tariffs, tighter semiconductor export policy, more restrictions from the Committee on Foreign Investment in the U.S. or other policies,” he said.
He ticked off several examples of heightened espionage to make his point, saying “China is conducting espionage on an unprecedented scale.”
For one thing, Chinese businesses are seen as inseparable from intelligence services. He quoted Harvard Kennedy School historian Calder Walton as saying that Chinese businesses are required to work with its intelligence services whenever requested to do so, which means that these intelligence services are now “effectively silent partners in Chinese commerce with the outside world.”
The U.S. is already poised to ban some investments in China. This week, the Office of Management and Budget disclosed that that a new rule that would ban certain U.S. investments in artificial intelligence in China in the final review stage.
The rule will also require U.S. investors to notify the Treasury Department about some investments in AI and other technologies, including semiconductors, microelectronics, and quantum computing that can be employed for developing military capabilities.
Reuters reported that the final rules may be released in the “next week or so.”
Cembalest detailed how one Chinese state-linked firm hacked hundreds of thousands of internet-connected devices in the U.S. and other countries. Other hackers have found their way into U.S. transport, telecom, water, and electricity networks. “Chinese cargo cranes used at U.S. ports had embedded technology that could allow Beijing to secretly control them,” he added.
China’s hackers are also involved in information theft of “sensitive information obtained during high level government security clearances, exposing 22 million current and former officials to extortion,” he said. Cyberattacks affect almost every sector, including healthcare, financial services, defense, energy, government facilities, critical manufacturing like aerospace), video gaming, and faith-based organizations, he added.
Foreign companies operating in China in joint ventures are required to allow Communist Party cells to be established inside them, he noted, and that means the Chinese operatives can steal technology, IP, and other data through the company’s worldwide networks.
“U.S. and China are intertwined via bilateral central bank holdings, trade, and foreign direct investment to a much greater degree than adversaries of the past,” Cembalest said. “But as time passes, this argument seems less convincing to me; ongoing geopolitical tensions suggest that US investors in Chinese equities ‘take the money and run’ once they achieve their target returns.”
