The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Hudson Lockett

HONG KONG, Jan 7 (Reuters Breakingviews) - The bull case for China's stocks is on its face compelling: firms in the People's Republic are undervalued and often enjoy higher cash flow and profitability relative to global peers. Some of the largest and most popular among global investors, such as tech group Tencent 0700.HK and battery maker Contemporary Amperex Technology $(CATL.UK)$ 300750.SZ, just closed out 2024 with double-digit gains fuelled by hopes Beijing will finally take more substantial measures to boost sluggish growth.

But it is equally clear that this bull case is precarious at best. Case in point, on Monday, the U.S. Department of Defense added Tencent and CATL, with a combined market value of $640 billion, to a list of companies it says work with the Chinese military. Both have denied the link, with Tencent saying the decision was “clearly a mistake”.

On first glance, there are no material consequences, in contrast with other lists published by the Treasury or Commerce Department that restrict access to American investment or goods. Nor is inclusion necessarily permanent. Facial recognition software provider Megvii was removed from the list on Monday, a year after first appearing - and despite its continued presence on the Commerce Department’s entity list, which has barred it from buying U.S. products since 2019.

Yet, the perception risk alone sent investors scrambling for the exits, with Tencent’s shares dropping as much as 7% in Hong Kong on Tuesday. That is bad news for the trillions of dollars tracking benchmark indices that include Chinese stocks. Tencent alone carries a weighting of more than 16% in the MSCI China .MICZ000I0NUS index. For CATL, the blacklisting raises awkward questions for Ford F.N, which is building a battery plant using licensed technology from the Chinese firm.

Moreover, the threat to Chinese stocks look set to spread. After authorities pulled out the stops in 2024 to prop up local markets - resulting in the benchmark CSI 300 index .CSI300 rising more than 15% for the year - that gauge fell more than 5% in the first week of 2025 on renewed concerns of growth as U.S. President Donald Trump prepares to take office.

For any fund manager who upped their exposure on the back of last year’s rally, they may soon find out that buying into the bull case is more trouble than it's worth.

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CONTEXT NEWS

The U.S. Defense Department announced on Jan. 6 that it had added Chinese internet group Tencent and battery maker CATL to a list of firms it says work with the People’s Liberation Army.

Both Tencent and CATL, among the most popular with foreign investors, denied working with China’s military and said the decision was a mistake. Shares in the two companies fell as much as 6% and 7%, respectively, in Asian trading after the announcement.

China’s benchmark CSI 300 index is down more than 4% so far this year amid renewed concerns over growth and disruption to trade from the incoming Trump administration.

(Editing by Robyn Mak and Ujjaini Dutta)

((For previous columns by the author, Reuters customers can click on LOCKETT/ hudson.lockett@thomsonreuters.com))