Chinese ADRs Delist & A Bull Case for Base Metals
September 2, 2022
Will Chinese ADRs Delist?
The possibility that over 200 Chinese ADRs could be delisted from US exchanges has been looming over markets since Dec 2020 when Congress passed the Holding Foreign Companies Accountable Act. The act directs the SEC to prohibit the listing of a security if the US Public Company Accounting Oversight Board is prohibited from inspecting the auditor of the listed company for three consecutive years.
Last Friday, US and Chinese regulators seemed to have made a breakthrough in keeping Chinese companies listed in the US. The two sides signed an agreement permitting US regulators to investigate public accounting firms located in China and Hong Kong. US regulators were quick to quell expectations stating, “the real test will be whether the words agreed to on paper translate into complete access in practice.” SEC Chair Gary Gensler simply said, “the proof will be in the pudding.” Despite the less than optimistic comments from US regulators, the agreement is a sign that progress is being made as well as vital first step in avoiding a complete delisting scenario. Goldman Sachs’ China analyst predicts a 50% delisting probability, down from 95% high in March.
Despite the improved probability, delisting remains a considerable risk for many Chinese stocks because a successful outcome depends on complete and consistent transparency and cooperation from the China Securities Regulatory Commission over multiple inspections. In the event of a forced delisting, Goldman estimates Chinese ADRs could fall 13%, pushing the MSCI China Index down by 6%. Should things continue to progress positively and no forced delisting occurs, Goldman believes there could be an 11% boost to PE ratios. We believe the majority of Chinese ADR’s will ultimately remain listed in the US. However, wherever possible, we recommend purchasing or converting existing shares from ADRs to the Hong Kong equivalent listing to mitigate any future unforeseen risks.
A Bull Case for Base Metals
Rebounding in Q1 under high inflation, base metals have reversed early gains and are now down over 20% YTD. Western recession fears and a Chinese property slump have weighed heavily on demand and prices. Metal stock to usage metrics remain over 50% below multi-decade averages amidst weak supply. A shift in global GDP toward renewable energy, as well as weak supply dynamics, provide upside opportunity for base metals.
Global metal producers have been underproducing for years. South American leftist-run countries are largely adhering to promises of increased mining taxes and environmental clean-ups. The increased output of smaller producer countries will not make up for stagnation of larger producers. For the first time, ESG concerns are competing against mining countries’ cash cows. High energy prices have also led to thinning margins for refiners, only to be further exacerbated in competing with Europe for energy this winter.
Recession fears in western markets and China have curtailed demand. The private sector has continued to reduce CAPEX. The property slump has revealed the sector’s large contribution to China’s GDP, typically a top global consumer of metals. As China looks to emerge from Covid less reliant on its property market, a shift in GDP growth tactics to renewable energy is being circulated as a potential solution. China is one of the largest investors in the space and a large infrastructure spend would solve multiple objectives: reliance on cheap Russian oil (temporary), fractured power grids, rising graduate unemployment, and GDP growth. Western countries, under US Inflation Reduction Act and EU Repower EU, have already committed to renewable spending totaling over US$500 billion. Base metals will be a main benefactor and key input to these projects alongside the electric vehicle space.
Near-term recession fears and falling inflation have historically been negative for commodities, however, today’s environment remains unique. With the US, Europe, and China (~50% of the World’s GDP) moving to sovereign energy independence and expanding military spend, base metal demand is set to expand over the medium- to long-term. Short-term volatility, as supply fluctuates and renewables sovereign spending takes hold, will create attractive entry points in the near term.
DEFINITIONS & DISCLOSURES
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This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.
The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 738 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.