Over a longer investment horizon, CIO believes current valuations for Chinese stocks are attractive.(ddp)

As we discussed in our white paper “Pivotal November? The future of US–China engagement,” all foreign companies listed in the US must comply with the registration and reporting provisions of the Securities Exchange Act of 1934 and the Holding Foreign Companies Accountable Act (HFCAA, 2020). More than 50 jurisdictions comply with this US requirement. Mainland China and Hong Kong until recently had not, which created a risk that the American depositary receipts (ADRs) of approximately 200 Chinese companies could be delisted from US exchanges.

On 26 August, US and Chinese regulators took an important first step toward bridging their differences. They signed an agreement detailing a framework that would allow the PCAOB to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong.

Another major breakthrough in this saga took place today, when the PCAOB released a public statement that it had "secured complete access to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong" for the first time in history. The statement referenced the fact that "more than 30 PCAOB staff members conducted on-site inspections and investigations in Hong Kong, reviewing thousands of pages of documents, conducting interviews and taking testimony over a nine-week period from September to November."

While this does not completely eliminate the delisting risk, the announcement removes the sword of Damocles that has been hanging over Chinese ADRs for years. The PCAOB was careful to offer a caveat in its public statement, namely that "should People’s Republic of China authorities obstruct or otherwise fail to facilitate the PCAOB’s access – in any way and at any point in the future – the Board will act immediately to consider the need to issue a new determination." And yet, the tone of the PCAOB's statement was impossible to miss: the risk of delisting has been reduced significantly.

Looking ahead, we think Chinese equities will perform in line with peers in the coming months. The easing of COVID-related restrictions in certain cities has fueled hopes of China being on track for a full reopening. This should support certain sectors that will directly benefit from life getting back to normal. We believe the pharma and medical equipment, consumer, internet, transportation, capital goods, and materials sectors are likely to be the key beneficiaries, either in the earlier or later stages of any reopening.

Our emerging market internet and e-commerce thematic recommendation should also be supported by these developments, given the large representation of Chinese ADRs in the space.

Over a longer investment horizon, we believe current valuations for Chinese stocks are attractive. Their relatively low correlation to European, Japanese, and US equities also makes Chinese equities a valuable diversifier in a global portfolio.

Main contributors - Alejo Czerwonko, Thomas McLoughlin

Content is a product of the Chief Investment Office (CIO).

Original report - US-China ADR saga: Sword of Damocles removed for now, 16 December 2022.