Risks of investing in China exaggerated: analyst

Country’s stock market still a better bet than U.S. counterpart, new report says

For the past year or so, it’s been very profitable to avoid the once-hot Chinese stock market and load up on stocks in the U.S. As of Friday, a yardstick of U.S. stock prices, the S&P 500 index, was up 19 per cent from a year earlier. The FTSE/Xinhua China 25 index, a measure of blue-chip Chinese stocks, had fallen 17 per cent.

It’s easy to see why. In the U.S., economic growth is accelerating and the profit margins of its corporations have risen sharply. China, while still a key motor of global growth, is facing significant headwinds from a poorly regulated financial sector and signs of a slowdown in its important manufacturing industry.

What’s not so easy is to figure out where we go from here. Can American stocks continue to outperform indefinitely? Is it time to flee China’s uncertainties?

No and no, suggests one of the country’s more astute observers of the financial scene, Peter Berezin. In a new report, Berezin, managing editor of Montreal’s Bank Credit Analyst, finds that China’s stock market is probably a far better bet than that of the U.S. over the coming few years, despite the extra risks that are inherent in an emerging market with less transparency and regulatory oversight.

Emerging markets — formerly poor countries that have enjoyed rapid growth — have fallen out of favour recently. Stories abound about their financial troubles. So just as the world economy is poised to speed up after years of sluggishness — a formula for export and investment gains in emerging markets — the flow of money into these countries is drying up.

That’s because the prospect of better times a year from now is being trumped

As many investors lump all emerging markets together, China has suffered from investor jitters.

by the perception of dangers right now. But the problem isn’t universal. It’s concentrated in badly managed countries. Argentina is a prime example, notes Mar- tin Schwerdtfeger, a senior economist with the TorontoDominion Bank.

In spite of some impressive underlying strengths in its economy, overly politicized decision-making — including confiscation of private assets and brazen falsification of inflation statistics — have kneecapped Argentina’s solvency and attractiveness to investors. As a result, the value of its peso has melted by 35 per cent over the past eight months.

Turkey faces a similar problem of politicized government decisions hurting a fundamentally strong economy. With rapid growth dependent on foreign investment flows that are now dwindling, Turkey’s lira has fallen by 18 per cent in this period.

As many investors lump all emerging markets together, even the powerful Chinese economy, second-largest in the world, has suffered from investor jitters.

That’s not completely irrational. China has a financial sector that’s been allowed to expand rapidly outside the traditional banking industry, creating speculative excesses and credit risks that will need to be reined in. If China’s manufacturing sector were to suffer a serious slowdown, its economy would indeed be in trouble.

But these dangers are exaggerated by many observers, Berezin believes.

A financial crisis isn’t likely because the central government has ample resources to bail out any troubled institutions, while one recent sign of a factory slowdown is contradicted by other indicators suggesting that growth actually seems to be speeding up.

The real point, Berezin notes, is that “no matter how bad the story, there is almost always a price at which it is worth buying in,” and China exemplifies this, with stock prices today that are low enough to provide insurance against lots of risk.

The U.S. stock market, by contrast, is solid and relatively safe, but stocks are clearly overvalued right now. Over the coming five years or so, an investor in U.S. stocks would still be likely to continue making money, Berezin believes, but with prices already high by historical measures, gains should be modest, with inflation-adjusted returns perhaps averaging about three per cent annually.

“Investors searching for higher returns should look outside the U.S., with China in particular offering a compelling risk-reward tradeoff,” he concludes.

Of course, that doesn’t mean to jump in wholesale. A prudent investor might simply shift a modest part of her portfolio into China, perhaps using a diversified mutual fund or exchange-traded fund.