Are US Investors Underweight China?

The paradox of Chinese stocks

Ray Dalio has been going around selling his long-winded story about China’s irresistible rise to anyone who would care to listen. As long-cycle theories go, his take is not entirely unpersuasive. His thesis is that the world is witnessing a hegemonic transition. China, he tells us, will be next unipole. US investors, he warns, are dramatically underweight China. They should go in big. His thesis echoes that of Arvind Subramanian, who argued in 2011 that in a couple of decades, the world will be unipolar, with China as the unipole. Put simply, his case was that ‘China’s dominance is a sure thing’. BlackRock, having secured access to the Chinese investment market, has a more tempered but similar thesis. Global investors aren’t putting enough money into China, the giant asset manager argues. Unlike George Soros’s polemic, the thesis seems quite plausible and reasonable. So, are Dalio and E 52nd St really on to something? Or is there reason to doubt the obvious thesis?

The Dalio-BlackRock thesis is based on the idea that, having already overtaken the US in abstract purchasing power parity units, China will soon overtake the United States to become the world’s largest economy. This may very well happen—we should surely expect China to grow faster than the US as it closes the technological gap. At $14tn, China’s economy is two-thirds as large as that of the United States. Let’s assume that China will indeed become the world’s largest economy over the next decade or two. Does that not imply the world’s greatest investment opportunity?

The recent past offers some guidance. China has grown dramatically over the past three decades. If we start the clock in 1994, we note that while the US economy has trebled in size, China’s economy has grown 26-fold. This is undoubtedly the greatest economic growth story in history. Looking at the two together really hammers home the point:

Yet, here’s the astonishing thing. Despite the fact that Chinese GDP has grown by a factor of 26 and US GDP has only grown by a factor 3 since 1994, the US stock market has outperformed the Chinese stock market over the same period:

The next table displays some basic statistics on monthly returns for the Shanghai Composite and the S&P 500 since January 1994. US stocks have returned 6.8 percent per annum, while Chinese stocks have returned only 4.6 percent per annum. Moreover, the Shanghai Composite has been twice as volatile. As a result, risk-adjusted returns, as measured by the Sharpe ratio (SR), have been dramatically poorer for Chinese stocks (SR=0.17) compared to US stocks (SR=0.54). There is no escaping the fact that investors in Chinese companies have done poorly compared to investors in US firms.

This is an astonishing but underappreciated fact. How is this even possible? Shouldn’t Chinese investors have seen returns commensurate with economic growth? What gives?

What explains this extraordinary divergence between economic growth and stock market returns is the fact that the stock market is not a barometer of the economy at all. Investors may do poorly even if the economy is growing rapidly if, for whatever reason, companies fail to capture the growing surplus. The growing economic surplus may be bid away due to market competition, be captured by workers because of their high bargaining power, be confiscated by the government in the form of higher taxes, or be largely captured by non-publicly listed firms—perhaps because they are better connected to regime insiders. Some combination of these factors may explain the great divergence between economic growth and investor returns in China.

My point is very simple. If future economic growth equaled investment opportunity, then there would’ve been no better time in history to invest in China than at the beginning of the Chinese take-off in the early-1990s. Yet, as we have seen, even as the Chinese economy grew by a factor of 26, a dollar invested in Chinese stocks only grew by a factor of 4.6. Meanwhile, even though the US economy only grew by a factor of 3 over the same period, a dollar invested in US stocks at market weights grew by a factor of 9.4.

So, if the Subramanian-Dalio-BlackRock argument holds any water, US investors should’ve paid dearly for missing out on Chinese exposure during the past 25 years. But they did not. This makes me very skeptical of the argument that US investors are dramatically underweight China. In order to buy the argument, we have to believe that the historical relationship between Chinese growth and investor returns will be overturned in the near future. But is there a good reason to expect a structural break in the Chinese regime of accumulation? There may well be. But I have yet to see any evidence of it.

So, the obvious case for US investors being underweight China is not as compelling as it looks at first sight.