Investors pull back, fearing China on the verge of a stumble

China's economic engine powers on, but some consultants and managers are becoming more cautious about investing in the Asian giant — at least in the short term.

China’s economic engine powers on, but some consultants and managers are becoming more cautious about investing in the Asian giant — at least in the short term.

The long-term prospects for China remain solid, they said. But in the next year, increased cyclical volatility is expected because of uncertainty surrounding much-needed economic and social reforms.

Some investors also question whether Chinese stocks are becoming overvalued, even flirting with bubble territory.

“There’s no question that China is a key determinant driving the Asian economic growth and a significant contributor to global growth in the long term, but in the shorter time horizon, cyclical factors may be more dominant,” said Leon Goldfeld, chief investment officer of HSBC Global Asset Management.

Stock valuations are becoming expensive compared with developed markets such as the United States, according to consultants. The Hang Seng Index gained 52% last year, while the Shanghai Composite Index was up 80%, both partly because of government-led economic-stimulus measures.

However, to stanch inflation, the excess liquidity injected into the economy to sustain growth during the global economic downturn needs to be removed, said Mark Brugner, head of manager research for Asia at Towers Watson & Co.

“There is concern of an asset price bubble, of asset inflation, but I think the government and The People’s Bank of China [China’s central bank] have signaled that they are trying to balance their objectives concerning inflation and maintaining economic growth,” he said. “A lot will definitely depend on how successful they are.”

Tapan Datta, head of economics in the global asset allocation division of Hewitt Associates LLC, also expressed caution. “The macroeconomic view is cloudier [in 2010, compared with 2009], with potential rising interest rates and additional monetary tightening in China,” he said.

China has led global economic growth in the past nine months. In the long term, as financial prowess is expected to shift to emerging markets from developed markets, China is still expected to be at the forefront of that movement, despite increased short-term uncertainty.

China’s gross domestic product grew 8.7% last year.

Last month, China surpassed Germany as the world’s largest exporter, and the United States as the world’s largest automobile market.

China this year also is set to move ahead of Japan to become the world’s second-largest economy, based on GDP Its share of global consumption, which is linked to about 1.3 billion people — the world’s largest country in terms of population — is also set to overtake the United States as the largest consumer market in the next decade, according to a report from Credit Suisse Group AG.

By 2020, China’s domestic consumption is estimated to total 23.1% of the global market, compared with 22.9% for the United States, which is the largest consumer market in the world. Additionally, China holds about $2.4 trillion in foreign-currency reserves, providing plenty of fuel for growth.

Virginie Maisonneuve, head of global and international equities at Schroders PLC, for one, remains bullish on China. The country remains “much more attractive than many countries in the developed world,” she said.

Schroders has been adding exposure to China since the fourth quarter of 2008.

“Even at a normal or a declining rate of growth” in the next several years, China’s prospects still look better than many developed economies’, said Ms. Maisonneuve, whose firm has about $14 billion in assets under management in active fundamental international and global equity strategies.

Institutional investors in Europe and North America generally invest in China within a broader emerging-markets portfolio, which generally contains 5% or less of their total assets, consultants said.

China represents about 2% of the MSCI All Country World Index and about 18% of the MSCI Emerging Markets Index. Although exposure remains small, many are looking at how and when to increase their weighting in Chinese equities.

“The average [institutional] investor’s exposure to China at this point is still quite small,” said Bin Shi, a portfolio manager for UBS Global Asset Management. “A lot of Chinese companies are majority-owned by the state.”

Therefore, Chinese companies are underrepresented in free-float-adjusted, market-capitalization-weighted benchmarks such as the MSCI Emerging Markets Index, Mr. Shi said.

“Another issue for foreign investors to access the domestic-China market is related to the Chinese currency,” he said. “As long as [the government’s] capital control measures are in place, I don’t think the door will be wide open; however, the door is gradually getting wider and wider.”

Thao Hua is a reporter for sister publication Pensions & Investments.