Political risks are deteriorating in Hong Kong, China, and Taiwan but investors do not seem to care.
In smaller emerging markets, particularly in frontier, one might reasonably expect a substantial negative reaction in equities following developments of the sort recently seen in these three markets.
We acknowledge three candidate explanations below, but we smell a whiff of consensus complacency.
These events have been a long time coming (ie they are expected) and already baked into valuations; on this interpretation, the new Hong Kong security law merely plugs a constitutional gap dating back to the UK handover and continues a process set in motion since the 2003 aborted Sedition Law.
Minimal impact is expected on macroeconomic or corporate fundamentals; ie behind the drama of the headlines, the day-to-day operating outlook will not change, because Hong Kong residents are used to disruption from protests (and Covid-19), China still needs a fully functional finance hub in Hong Kong, US President Trump is ultimately unlikely to risk the Phase 1 trade deal with China or damage investments by US corporates by revoking Hong Kong's special status, and in Taiwan, as long as a balance of power is maintained (ie the implicit US security guarantee is in place), hot military conflict is unlikely.
Other factors are outweighing these events for investors (eg liquidity flows both locally, as fixed income and real estate yields drop and wealth switches into equity, and internationally, as the largest emerging markets, like China, Taiwan and Hong Kong, attract funds, both because of their sheer size, particularly for passive funds, and high exposure to the technology sector, particularly for active funds) – respectively, China/Taiwan/Hong Kong are 39%/12.5%/3.6% of MSCI EM and have technology making up 40%/65%/0% of their indices.
In our view, a lengthy lead up or a well understood pattern can still result in an unforeseen magnitude of change if the context has changed since the start of that lead up or pattern. The nature of China-US relations is very different (more fractious) compared with a sample of historic moments:
1979 when US President Carter terminated the US-Republic of China (Taiwan) defence treaty in order to establish better relations with China;
1997 when the UK returned Hong Kong to China;
2003 when protests broke out in Hong Kong against the Sedition Law;
2006 when China's weight in MSCI first breached 10%, or 2013 when its weight breached 20%).
Is the apparent complacency an opportunity for those willing to look elsewhere in large EM (eg India for a mix of value relative to history and growth, in part due to potential manufacturing gains from China)? We think so.
Hong Kong: Higher risk to special status
After the passage of the new security law, Hong Kong faces potential fresh protests (with elections in September) and higher long-term risk for its special status as a finance hub if the US revokes its special status – whereby each law of the US covering, for example, finance, trade, security and technology currently treats Hong Kong differently from mainland China – or if the parameters of the currency peg change – eg a wider band or a different choice of pegged currency.
China: Worsening relations with US
Strongly worded criticism of the Hong Kong security law from Secretary of State Pompeo and tit-for-tat visa restrictions this week follow a pattern throughout the year to date (doubts over the Phase 1 trade deal, tighter restrictions on listed securities of Chinese corporates, public friction around Australia, India and Taiwan, tit-for-tat journalist effective expulsions, dispute over the cause of Covid-19, accusations of compromising the independence of the WHO).
All of this is taking place in the context of a US election where both candidates are attempting to outdo each other's hawkishness on China (with the only difference being Biden's preference for multilateralism over Trump's unilateralism).
Taiwan: Signal of more likely future conflict
Mainland China has been adopting more aggressive policies on Taiwan since the election of the Democratic Progressive Party's Tsai Ing-wen as president in 2016 (along with a legislative majority) and this has continued after her re-election in January 2020 (on higher turnout, 75% versus 66% in 2016).
The new security law in Hong Kong may be a demonstration to Taiwan's electorate, leadership, and international supporters of Taiwan independence that "one country, two systems" is ultimately unworkable. At a minimum, the conduct of military drills by China around Taiwan and the passage into US law of the Taiwan Allies International Protection and Enhancement Initiative (TAIPEI) demonstrates that sensitivities on Taiwan show no signs of abating.