Is China’s Bear Market an Opportunity?

Key Points

  • China’s stock market pullback this year has been in line with the average annual drawdown; historically, this volatility has tended to produce double-digit annualized gains.

  • The recent drop seems to be driven by a regulatory crackdown, not an economic slowdown, with the market not responding to the economic outlook, but to the policy uncertainty.

  • Regulatory reform may continue, but the market’s reaction may be overdone.

In the United States, the political process addressing issues of tech giant data becoming more of a public good, user privacy, and the labor impact of the tech-enabled gig economy is slow moving. But, in China, it can seem to come overnight.

In response to recent regulatory policy changes, Chinese stocks are in a bear market, as defined by falling more than 20% from its high. The slow slide in China’s stock market from its February peak sharply accelerated last week and spread beyond education and meal delivery stocks targeted by the latest regulatory crackdown. The stocks in the MSCI China Index plunged 14% in three trading days as the view changed from calmly interpreting regulators’ actions as only focused on a few big tech firms to alarm that no industry is isolated from a sudden rush of regulatory reforms. Investors in emerging markets have felt the drop, as China currently makes up one-third of the MSCI Emerging Market Index. This has left the MSCI Emerging Market Index flat year to date.

This outcome for investors isn’t new. Historically, investing in China’s stock market has come with high volatility—and high returns. This year, MSCI China Index has gone from being the strongest in the world, with a 20% gain year-to-date on February 17, to a year-to-date loss of -12% as of July 30, making it one of the world’s worst performers. This year’s peak to trough drawdown of -27% is in line with the -28% average annual drawdown over the past 20 years since China entered the World Trade Organization in 2001, as you can see in the chart below. Historically, investors have tended to be compensated for this heightened volatility with double-digit annualized total returns over the past 20 years (from 7/30/01 to 7/30/21 the MSCI China Index produced an annualized total return of 11%).

Annual performance of the MSCI China Index

Source: Charles Schwab, Factset data as of 7/31/2021. Past performance is no guarantee of future results.

Limited spillover

Investors often equate bear markets with economic recessions. But, for China, that isn’t usually the case. In fact, China’s economy is far from recession on a wide variety of measures produced both inside and outside of China’s borders. China’s purchasing managers index remains in expansion territory. South Korean exports to China have surged in recent months. U.S. companies’ second quarter earnings have cited strength in China, including Coca-Cola’s reporting of demand running ahead of 2019.