In focus

China’s latest Covid crisis, war in Ukraine: observations for investors


China’s draconian Covid policies have dominated headlines in recent days, with protests erupting in many cities.

It remains to be seen whether the Chinese government will heed protestors’ anger and loosen lockdown rules – or reinforce them to quash both the unrest and the current uptick in Covid cases. There may be a middle way involving strict lockdown to contain the current spike, with a promise of looser policy to come.

But while China is currently in the spotlight, it’s far from the only risk facing investors. Speaking just as the protests at the latest lockdowns were gaining momentum, our expert panel – former head of UK armed forces General Sir Nick Carter, Schroders fund manager and Russian national Vera German, and Sir Sebastian Wood, chairman of Schroders China – offered their insights into the current heightened geopolitical tension. Stuart Podmore, Investment Propositions Director, chaired the debate.

When will China lift zero-Covid policies?

Sir Sebastian Wood: Covid policy is a huge economic headwind that is severely suppressing China’s economic growth. But we sometimes forget that China’s policy has been a success in public health terms. Deaths from Covid per million people are around four in China, compared to over 3,000 in the US and UK.

However, the policy of using targeted lockdowns to stop community transmission is now breaking down because new variants are so contagious. Recent weeks have seen leadership calls for an accelerated vaccine drive and more hospital beds - this suggests China’s leadership want to prepare the country to live with Covid like the rest of us.

But the policy of targeted lockdowns continues, presumably as a way of slowing the spread and buying time to prepare the public health system better for the wider wave of infections to come.  So, while I think Chinese policy is clearly in transition, we’re not out of this difficult phase of lockdowns and impact on economic activity yet. 

The Chinese government has been treading carefully on vaccinations. Forcing reluctant elderly Chinese to be vaccinated risks causing public ill-feeling and the government is more sensitive to this than many western commentators realise.  But we should expect now to see progressively more encouragement to get the elderly cohort triple vaccinated. 

What did the 20th Party Congress signal on Chinese domestic policy?

Sir Sebastian Wood: The Congress confirmed the shift from a laissez-faire era of economic growth to a more managed form of growth. Part of this is to do with cutting carbon emissions and making the economy more environmentally sustainable. 

It's also about addressing widening wealth inequality, hence the new focus on “common prosperity”. The Chinese leadership have watched political polarisation and growing nationalism in some western democracies with unease, and they put it down in part to widening inequality. They are trying to pre-empt that happening in China, hence a growing emphasis on redistribution and continued determination to expand the middle class. 

Alongside this is a growing emphasis on self-sufficiency, given the perception that the US may try to hold China back. China feels it needs to be less vulnerable to external pressure on critical inputs like food, energy and key supply chains. This means a big, multifaceted industrial policy focused on emerging technologies. 

Contrary to some media analysis, it's not necessarily the case that the new leadership team will just be “yes-men” who are uninterested in economic reform. Three of the four new Politburo standing committee members have run China's most dynamic regions. They are likely to understand the importance, in particular, of a vibrant private sector as the creator of all net new jobs in China's cities. 

War in Ukraine: what are the wider implications?

General Sir Nick Carter: I think it’s worth reflecting on the fact that the global system that has largely ensured our stability and prosperity for the past 70 years is being undermined by events.

The war in Ukraine clearly is uppermost in our minds in Europe. We can trace the first phase of this back to 2014 when Russia used political warfare and coercion to try and bring Ukraine into its orbit. The invasion this February marked the start of phase two as Russia tried to dislodge the Ukrainian leadership, which failed. Then its focus turned to eastern Ukraine and the four regions that Mr Putin wants to annex, which also didn’t succeed.

We’re now in the fourth phase in which we’re seeing Putin try to make this a “people’s war” via mobilisation of Russians and attacks on Ukrainian infrastructure, like the power networks. The war is likely to simmer over the winter, with both sides regrouping in the spring.

Escalation is the great risk that we all need to watch. We’ve already seen possible escalation from Russia in terms of the attacks on the Nord Stream pipelines in the Baltic sea. We know that Russia has the capability to conduct seabed warfare against areas such as pipelines and cables. Nor can we rule out space or the cybersphere as potential domains for attack. Then there is the information war, in which Russia is an expert. That kind of non-attributable escalation is most likely to occur in the next six months.

I think a nuclear attack is unlikely. Firstly, it’s difficult to identify a target for a tactical nuclear weapon. Secondly, Russia would lose the support of China and India. And thirdly, the NATO alliance would respond on an enormous scale, using conventional weapons.

That still leaves questions over the duration of the war and a likely end-game. Who determines what defeat or victory look like for both sides? Currently I can’t see either side being willing to compromise in the next year.

The economic implications of the war mean the durability of western cohesion remains a doubt. Next winter will be even harder for Europe from an energy perspective, given there will be no Russian gas in our stockpiles. For Germany in particular, which has been the main beneficiary of cheap Russian gas, manufacturing goods will become more expensive, damaging export competitiveness.

Away from Russia/Ukraine, we must think about the Middle East, where there is increasing nervousness over the US’s commitment to underpin regional stability. Iran faces an internal rebellion, particularly from women. It remains to be seen whether this poses a genuine threat to the regime. Iran will also have drawn conclusions about the value of a nuclear weapon as it watches events play out in Ukraine. If Iran takes further steps towards a nuclear capability, what will that mean with a more right-wing Israeli government in place? How will Saudi Arabia perceive that? Turkey is a factor too, and its role in the Middle East is evolving.  

The Gulf may be booming in economic terms, but the overall political fragility of the region is one to watch.

How are Putin’s actions viewed from a Russian perspective?

Vera German: Putin is using Ukraine to quell domestic issues, as well as to reassert Russia as a country to be respected on the international stage. Domestically, the oil boom of the 2000s enabled a rise in living standards and people didn’t question how freedoms were being curtailed. That began to change as economic times became more challenging. Finding an external opponent is an obvious way of trying to unite the population against that third party.

We can trace the current situation back to the 1990s and the end of the Cold War. In many ways it was a surprise that the Cold War concluded so peacefully but perhaps there was just a time lag in terms of reaction. Since then, there has been rising anxiety about how the privatisation of industry was handled, and the growth of western influence in Russia.

State propaganda in Russia regarding the war is very extreme and has little to do with how we in the West perceive the situation. But it does play to this sense of anxiety that has been present in Russian society since the 1990s.

Whatever happens over the next year, or even five years, the long-run issue is that this war has effectively split the country down the middle. Almost everyone in Russia has friends or family or other ties to Ukraine. This means society is very divided on the war and it’s hard to see what could put it back together, even when the violent part of the conflict ends.

What of China and Taiwan? Have risks there risen?

Sir Sebastian Wood: There’s a perception that China is accelerating its timetable for re-unification with Taiwan, but there is no visible evidence of this. President Xi has set 2049 as the date for the “great rejuvenation” of China. The leadership has also talked of reunification with Taiwan as a precondition of that rejuvenation, so that implies a deadline of 2049, but leaders have not publicly stated any earlier date. On the contrary, the stated policy remains peaceful reunification, but alongside a message of deterrence that if Taiwan moves towards de jure independence, China reserves the right to take action and has the military capability to do so. 

Any early Chinese attempt at forcible reunification looks highly unlikely. The Chinese leaders know that the US would almost certainly get involved on the Taiwanese side so China would be inviting direct military conflict with the US, entailing enormous economic damage. The goal of economic development is, after all, still China’s overriding objective. 

In many ways, risk of conflict over Taiwan arises more from Washington than from Beijing. US policy needs to remain stable. Deterring China from attacking Taiwan and at the same time deterring Taiwan from declaring independence is a policy of “strategic ambiguity” that has kept the peace across the straits for decades. Any shift towards explicitly supporting Taiwanese independence would upset this balance and could push the Chinese leadership into running the risk of conflict, despite the economic price they’d pay, because of the domestic political consequences if they did not. 

2022 was always going to be a turbulent year for US-China relations, given the 20th Party Congress and the US mid-terms. China often becomes a political football in US election years. Presidents Xi and Biden probably now have a bit more political room for manoeuvre to improve relations, and their meeting in Bali was encouraging.

But this is only a cyclical improvement. The longer term, structural dynamic remains concerning. The recent ban on semiconductor exports is the first time we’ve seen a US measure that isn’t targeted at specific companies, but instead looks like deliberate attempt to hamper China’s wider economic and technological progress. This will reinforce Chinese conviction that the US is increasingly determined to hold China back. 

Against this backdrop, how do investors find value in emerging markets?

Vera German: Emerging market assets are the first to be sold in times of heightened fear and uncertainty. Following the recent Chinese Communist Party conference, for example, we saw a lot of blanket selling of Chinese assets. Investors simply dumped the whole asset class, rather than focusing on the impact on particular companies. That kind of market reaction, or overreaction, opens up opportunities for value stockpickers like me.

More broadly though, investors need to live with the idea of government intervention, especially if they want to invest in emerging markets. Developed markets are hardly free of government intervention either although it may take a different shape. The system of lobbying in the US is an example. In my team, we don’t just look at valuations. We also have a risk score that we assign to each stock and we need to feel that the potential upside warrants taking the risk.

Equity investors need to develop a toolkit for assessing political risk. Investing isn’t just about mathematical models; you have to assess the unquantifiable as well. Many investors write off political risk as “too difficult”, which leads to wholesale selling. Or they try to understand but don’t have a framework for it and end up viewing it through their own lens.

Investors need to be thinking not just about what makes sense to them, but what makes sense to Putin or Xi, or whoever it may be. It’s not just maths and calculating cost of equity; it’s about understanding different perspectives and the world events that can make or break your investments.

In many ways, emerging markets represent the perfect hunting ground for value investors. The concept of value investing was really developed in the US in the 1930s when US markets were in a similar conditions to emerging markets today. There was limited information available, various different accounting standards, and a no grasp of the concept of shareholder value creation.

Value investing was very successful in the subsequent decades in the US because it was able to take advantage of those inefficiencies. For me as a value investor, the overreactions – both positive and negative – that we see in emerging markets make it an asset class with great opportunities today.

And finally, how should investors approach the coming year?

General Sir Nick Carter: We’re in a new era of global confrontation that is the most serious since the 1930s. It’s time to buckle up.

Sir Sebastian Wood: Thinking about Taiwan in particular, my advice is to be vigilant, keep a close eye on US politics, but don’t panic.

Vera German: Investors can’t swerve these geopolitical risks; we need to learn how to calibrate them. To do that, we need a grasp of history and to try understanding the world from another’s perspective, not just our own.