Ukraine war: risk of sanctions puts China stocks in valuation, geopolitical traps as companies face Russia dilemma

  • Chinese stocks are on ‘cheap sale’ after a US$2.4 trillion sell-off in both onshore and offshore markets since Russia invaded Ukraine
  • What investors cannot price, however, is the risk of sanctions on China’s biggest companies

Chinese stocks are on “cheap sale” after a US$2.4 trillion sell-off in both onshore and offshore markets since Russia invaded Ukraine. What investors cannot price, however, is the risk of sanctions on China’s biggest companies.

As a result, investors should favour markets that are least exposed to the secular US geopolitical conflict with Russia and China, according to strategists at BCA Research. The risk premium-compression trade, touted by strategists at Goldman Sachs, can possibly wait.

China has refused to condemn Russia’s military aggression in Ukraine, while also publicly opposing the mounting Western sanctions on the Kremlin. That stance has presented a dilemma for Chinese firms operating in Russia, including Xiaomi, Sinopec and Alibaba Group Holding, the owner of this newspaper.

“Chinese cooperation with other US rivals will provide more occasions for the US to punish China,” BCA strategists said in a note on March 28. “Since China will help Russia bypass sanctions, US sanctions on China are likely this year, sooner or later.”

Foreign investors pulled almost US$10.7 billion from the Chinese stock markets in the first half of this month, according to Jefferies, one of the worst drawdowns on record by the Stock Connect’s northbound investors. The capital outflow suggests global funds may see the market as a valuation trap.

“Outflows from China on the scale and intensity we are seeing are unprecedented,” the Institute of International Finance said in a report last week. “The timing of outflows – which built after Russia’s invasion of Ukraine – suggests foreign investors may be looking at China in a new light, though it is premature to draw any definitive conclusions.”

Concerns and uncertainty around geopolitical spillover risk and ADR delisting will probably keep equity risk premium at elevated levels until market-clearing events emerge, according to Goldman, which turned bullish on Chinese stocks about four months ago.

“The recent trough on March 15 could be a ‘false bottom’ that may precede a larger drawdown in ensuing months, which was indeed the case during the 2001, 2004, and 2006 corrective periods,” it added. With risk appetite already at an extreme low, the likelihood is small “unless tail risk scenarios or shocks materialise.”

The potential shocks cannot be ruled out for now, as China cannot afford to reject Russia for the many strategic benefits to its economy, according to BCA Research.

“China’s single greatest vulnerability is its reliance on oil imported from the Persian Gulf, which is susceptible to American naval interdiction in the event of conflict,” BCA said. “Russia and Central Asia form the second largest source of food, energy, and metals for China. Russia provides an overland route to the supply security that China craves.”

The risk of direct sanctions on China is high, according to Morningstar, if Beijing gets sucked into the Russia-Ukraine war and feels compelled to support the Russians.

“China will be mindful to avoid this,” said Lorraine Tan, Asia director of equity research. “If the war is prolonged, we see a high risk that the Biden administration will add companies doing business with Russia to its banned entity list.”

Author: Cheryl Heng, SCMP

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