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Chinese equities: Enter the dragon

15 Feb 2021

With China’s economy set to boom, have equity investors missed the boat or is the next phase of its growth story only just beginning?

China was the first country to catch Covid-19 and is on track to be the one of the first to get the pandemic under control. This is reflected in its economic outlook. China’s economy grew 6.5% in the fourth quarter of 2020 and is expected to expand by a further 8.2% this year, the IMF believes. The improved economic outlook is being priced into domestic equities. Following March’s Covid-19 sell-off, shares listed in China recovered to close at a 13-year peak in January.

While shares in Chinese companies trading in Hong Kong, known as H shares, are being overshadowed by political events in the province, most institutional investors, based on the surge in the CSI 300 index, are favouring shares trading on stock exchanges in Shanghai and Shenzhen, popularly known as A shares.

During the past year alone, the MSCI China A shares index gained 43%, more than double the level of the MSCI Emerging Market index. But A shares are not for the faint hearted. The asset class, which has only become widely accessible to international investors four years ago, is notoriously volatile with peaks in 2008 and 2015 being swiftly followed by sharp declines.

This raises the question: are investors who are entering the market now buying shares at their peak or will the growth spurt be less volatile this time?

No longer niche

Around a decade ago, Chinese equities would have been considered a niche strategy by institutional investors in the UK. Although shares in listed Chinese companies have been trading since the 1860s, stock markets only re-opened in 1990 after a near 40-year break instigated when the Communist Party took power. The market is also worth a fraction of US equities with a market cap of up to $4.7trn (£3.4trn).

Three factors have helped to make A shares more accessible. Over the past 10 years, the authorities in China gradually expanded the status of the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme, which allows a limited number of international investors to directly trade in Chinese bonds and equities.

Access to China’s equity markets for UK investors was further accelerated by the launch of the Shanghai-Hong Kong connect in 2014. This was followed by the Shanghai-London connect five years later. While the former initiative allows overseas investors to trade shares listed in Shanghai, the Shanghai-London connect initiative went one step further, allowing international investors to access A Shares outside of greater China for the first time.

But the third, and perhaps most decisive factor, is the gradual inclusion of Chinese equities in emerging market indices since 2018, such as the MSCI. In 2019, 472 large and mid-cap China A share companies were included. Today about a third of the overall index consists of such equities, meaning that investors with passive emerging market investments have significant exposure to Chinese stocks.

As a result, Chinese equities have increasingly been integrated into institutional portfolios. For example, local authority pension scheme pool London CIV has exposure to such assets through its £2.7bn Global Alpha Growth fund, which it launched in 2016 and counts digital retailer AliBaba as one of its largest holdings. It also has exposure in its £350m Emerging Market Equity fund.

Similarly, Border to Coast, another local government pension scheme pool, has appointed two China equity specialists to manage a mandate that could be worth up to £500m. Daniel Booth, the pool’s chief investment officer, explains that the inclusion of A shares in indexes has been a key factor in the decision to increase its exposure to China. “With the increasing weighting of China in the emerging markets benchmark, reflecting trends in the wider market, we felt it was appropriate to seek a specialist partner who will provide us with a local market presence,” he adds.

Nest, the government-backed workplace pension provider, has almost doubled its allocation to emerging market equities during the past year, taking its exposure to around £930m, or 6% of its assets, from £480m.

The surge in inflows is driven by a broader demand for emerging market equities rather than a focus on China in particular, believes Jonathan Vargas, an economist at the Institute of International Finance (IIF). He explains that while inflows into Chinese equities always tend to spike towards the end of the year, recent growth has been particularly strong. “We saw some $17bn (£12.4bn) of inflows into Chinese equities in the fourth quarter of 2020, which is significant,” he says. “But we believe it goes hand in hand with an overall increase of flows into emerging markets in general, independently of the asset class, so it is more of a systemic trend to watch.”

Dreamcatchers

But investing in such a relatively young asset class is a risk, as the 2015/16 Chinese stock market crash illustrates. The Shanghai and Shenzen exchanges surged by more than 100% in 2015, yet within a month the value of A shares listed in Shanghai dropped by a third and more than half of companies halted trading. A factor driving the higher levels of volatility is the dominance of retail investors, who account for more than 80% of A shares trading volumes across the Shanghai and Shenzen exchanges. This development has been encouraged by Chinese leader Xi Jinping, who has promoted retail participation in stock markets as part of the “Zhongguomeng”, China’s dream of economic prosperity.

A consequence of that is A shares trade at a premium to H shares as retail investors have driven up prices. Moreover, with retail investors focussing less on company valuations, the market is relatively less efficient. But this could be an opportunity for investors. An active manager with sound knowledge of the local market might be able to identify companies that have been significantly undervalued but have so far not been on retail investors’ radars.

A shares also offer institutional investors access to a broader spectrum of opportunities, in terms of sector allocation and overall stock count. While H shares provide exposure to a universe of less than a 1,000 stocks and sectors such as international banks and tech, the A shares spectrum covers some 3,500 companies with sectors ranging from domestic consumption to financials, media and leisure, overwhelmingly in the form of mid or small-cap companies which tend to have limited analyst coverage. Indeed, around a third of A shares currently have no analyst coverage.

The IIF’s Jonathan Vargas argues that the growing inclusion of Chinese equities in emerging market indices means that capital flows will become more stable and there is not going to be as much rent-seeking behaviour. “Investors are less likely to go in and out of the asset class,” he adds.

But the key factor driving institutional bullishness on China is the pace of its recovery from the pandemic, which has fuelled a positive macro-economic outlook, he says. “Viewed from a macro perspective, we are seeing a healthy balance of payments and growth forecasts of around 8%, which you are not going to see anywhere else in the world, apart from some Sub-Saharan economies,” Vargas adds. “A lot of this is because China was able to recover from the pandemic so fast, while many developed markets are still struggling.”

This is also a key reason for Nest’s increased interest in the world’s second largest economy, as Edoardo Cetraro, investment analyst for the defined contribution (DC) scheme, explains. “After the initial virus outbreak, China managed to effectively control the pandemic while many developed markets countries are still struggling to contain it. Despite most of the world’s economies contracting significantly in 2020, China displayed strong economic resilience,” he says. Cetraro ties this into the long-term trends for the region, which counter the trajectory of many developed economies “Over the next 10 to 20 years we expect China’s urbanisation rate to rise further – about 40% of the population live in rural areas. This presents opportunities to invest in companies that can profit from a rising middle class and outpace similar companies in developed markets.”

Challenges

But strong economic forecasts do not guarantee a challenge free investment, Vargas warns, adding that investors in China will continue to face several obstacles. “The biggest risks investors in China continue to face are the trade stance of the new US administration and regulatory intervention by Chinese authorities,” he says.

Incoming US treasury chief Janet Yellen has already indicated that she does not intend to diverge significantly from Trump’s hostile stance towards the People’s Republic, by describing China as the US’ “most important strategic competitor”, an indication that the Sino-US trade relationship will remain tense.

Another financial risk for those with exposure to Chinese equities comes not so much from the firms they are accessing through share purchases, but from risks in other asset classes. Credit risk is a prime suspect here. Since the global financial crisis, debt-to-GDP ratios in China have doubled, with corporate borrowing a key driver. Unlike US stock markets, which rely heavily on equity financing, only a fraction of corporate financing in China is funded by equities. Instead, Chinese firms rely on bank loans and earnings to fund their business. While this makes the underlying businesses less vulnerable to a short-term stock market crash, a credit crunch could potentially be more painful. In addition, real estate in China is also showing signs of overheating, a trend which in the past has had severe knock-on effects for the health of the economy.

ESG risks also remain high on the agenda of institutional investors seeking exposure to China. This ranges from labour rights and the treatment of minorities, such as the Uighur population. For Akademiker Pension, Denmark’s retirement fund for education workers, these concerns have been far reaching enough to commit to selling all of its Chinese bonds and equities, amounting to a divestment of more than €50m (£36.5m).

So far, no UK scheme has taken an equally drastic stance, but ESG risks around Chinese equities remain on their radar, as a Nest spokesperson acknowledges. For the auto enrolment provider, a key challenge remains how to combine increased exposure to the Chinese economy with the aim to become carbon neutral by 2050.

Despite these challenges, Vargas remains optimistic that China will be in a much better state to weather the challenges of the pandemic than many developed markets. He argues that one key appeal of Chinese equities continues to be in its sector composition and attractive equity valuations compared to developed markets. “China increasingly has its own legs to stand on, and as such will be less affected by global trade challenges or a taper tantrum that could hit other emerging markets. Yes, there will still be volatility, but this time it could be more manageable. In the end, investors will have confidence that China will always be China,” Vargas says.

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