Jonathan, Causeway’s international and global value equity portfolios have both direct H-share holdings as well as indirect Chinese exposure by investing in many companies with operations, revenues or other connections to China. As an expert in industrials, how do you view the China exposure in developed markets portfolios?

JE: Speculative booms and busts have—and will –occur in many geographies. Valuations become overextended, share prices fall, investors lose money, then retreat, and valuations return to more rational levels.

Unfortunately, the Chinese government has interfered with the local stock market, one of the most important free market mechanisms. But where does intervention stop? As a research team, we are now contemplating the ramifications of “national” policy to support employment and the extent to which it drags on Chinese corporate earnings. Cutting employees may become very challenging for Chinese companies, especially those that are state-owned. Compared to 2013, we have lowered our global and international portfolios’ weights in capital goods companies. Many of these multinational firms generate a sizable portion of their profits in China. They are vulnerable to deflation, particularly as Chinese demand slows for their products. We have placed more emphasis on spending by the Chinese consumer with holdings in such sectors as consumer discretionary and mobile telecommunications. For example, China’s vehicle ownership is less than 20% the level in the United States; car penetration will likely rise with improved affordability. Furthermore, the government has accelerated the replacement cycle and wants to remove the old, dirtier vehicles from the road. We are also looking at a sanguine outcome for luxury goods demand and tourism.

With surplus capacity in basic industries, China needs a solution to absorb its years of excess fixed investment. What are you anticipating?

JE: I think the government has already signaled its intent to export some of its construction and industrial excess capacity, as well as newer technologies in solar panel, machinery and telecommunications equipment, via the Silk Road Economic Belt and Maritime Silk Road (aka the Belt and Road initiative). This development strategy, first announced in late 2013, is designed to boost employment in China, as well as accelerate more capital convergence and currency integration globally, lessening dependence on the US dollar.

AJ: By investing in transportation and other commercial infrastructure (highways, railways, ports, and coastal facilities) across Asia, the Middle East, and Europe, China intends to improve trade and foreign relations, and find a productive home for its massive $4 trillion of foreign reserves. In our emerging markets portfolios, we increased exposure to Chinese-listed industrials companies that we expect to benefit from the Belt and Road initiative. However, by interfering with its own stock market, China has apparently postponed its drive toward a more market-based mechanism of resource allocation.

We have placed more emphasis on spending by the Chinese consumer with holdings in such sectors as consumer discretionary and mobile telecommunications.

Beyond the stock market, speculation also appears rampant in residential housing. What are the economic and portfolio implications of this housing risk?

JE: Housing remains an important store of value for the Chinese saver. We do not believe that the current overbuilt situation and vacant units are systemically dangerous, but they are additional examples of oversupply.

A sustained fall in house prices nationwide would likely crimp consumer spending, but not the banking system. House buyers either pay in cash or use modest levels of debt. Assuming rural-to-urban migration continues, low-end units in tier 2, 3, and 4 cities should experience rising demand. We have generally sought to avoid positions in Chinese property following the onset of speculative housing fever in 2010-11.

AJ: Ironically, weakness in the Chinese A-share market may help support local housing prices. In addition to housing, the only real investment choices for the retail investor are domestic equities, bank deposits, some wealth management products and (for those with the highest incomes) overseas investments. Volatility in the Shanghai stock market is teaching the highly-levered local investor a tough lesson about valuation. Through this year’s Shanghai-Hong Kong Stock Connect program and the recently implemented mutual fund recognition initiative, the Chinese government continues its efforts to facilitate cross-border investment between foreign institutional investors and the mainland. Assuming market connectivity and capital mobility improve, the enormous premium of A-shares relative to H-shares should eventually erode. The government’s market manipulation stymies this effort to bring best practices to China’s undeveloped markets. Despite this setback, we are still convinced that those best practices will eventually take hold in China, to benefit all investors.

Important Disclosures

MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.

Market Commentary

The market commentary expresses the portfolio managers’ views as of 7/15/2015 and should not be relied on as research or investment advice regarding any stock. These views and portfolio holdings and characteristics are subject to change. There is no guarantee that any forecasts made will come to pass. Any portfolio securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.