China is under-represented in traditional indices for both equities and fixed income. So, should investors focus on the country separately? And how should they structure their exposure?
One year on
We wrote on this topic in 2018 - but a lot can change in a year. The escalating trade war between the US and China has stoked financial market volatility and darkened the economic outlook. Global supply chains have been disrupted, hitting US and Chinese companies across the spectrum - from US soybean farmers to Chinese furniture manufacturers. There is little doubt that the trade dispute has unnerved investors about allocating to the world’s second largest economy. But the threat of US isolationism has pushed China to make friends elsewhere. From Israel to Italy, President Xi Jinping has been on a charm offensive to boost trade and investment. China has the second-biggest stock market and third-largest bond market globally; but is that enough for investors to consider it as standalone allocation against a backdrop of trade war uncertainties?
Below we offer an updated version of our article from last year on the different factors in asset allocation and portfolio construction that investors should consider when looking at China on its own.
The case for China
At some point in the process of portfolio construction, most investors stop and consider how they should allocate across key economies and regions like the US, the EU, Japan or emerging markets, in order to reach their investment objectives. Is China just part of Asia, or does it warrant the same level of attention as those major markets on its own? Glance at the numbers and you’d be inclined to agree with the latter.
Almost 20 per cent of the world’s population call China home: around 1.4 billion potential consumers, with steadily increasing incomes. Its GDP is more than 12 trillion US dollars, putting it second behind the US. Increasingly, China helps drive the world’s economy; it’s expected to contribute more than 35 per cent to global growth between 2017 and 2019, compared to a contribution of less than 18 per cent from the US.1
But China isn’t just growing fast. The dynamics of its economy - propelled by a powerful central leadership - are distinct from its neighbours across the rest of Asia and broader emerging markets. This implies a useful diversification for those seeking to optimise global portfolios.
On the face of it, the depth and breadth of China’s investment universe is as compelling as the macro picture. The relatively young onshore bond market is already one of the largest in the world, at around $13 trillion, while Chinese issuers comprise almost two thirds of the $1.1 trillion Asia bond market. The Shanghai and Shenzhen equity exchanges trade the A-shares of around 3,500 companies, with a combined market cap of almost $8 trillion (already eclipsing Japan: the market cap of the 2,000 or so companies listed on the Tokyo exchange is $5.6 trillion).2 And that’s before accounting for the hundreds of mainland companies listed on offshore exchanges in Hong Kong, Taiwan, London, Singapore or the US, including corporate behemoths like Alibaba and Tencent.
If all of China’s onshore and offshore equities were included in MSCI’s indices, it would represent roughly 42 per cent of the emerging markets index. For Asia ex-Japan, China would rise to almost 55 per cent of the index.3 As it stands, by November, China A-shares will represent a little over 3 per cent of the MSCI emerging market index.
This is an impressive leap, but it’s far from full inclusion. While China’s economic clout is indisputable - global assets shiver when its economy catches a cold - this is not yet the case for its capital markets. They remain tightly-controlled and sometimes opaque, particularly for outsiders unfamiliar with the territory. Meanwhile, it’s still not all that easy for global investors to get access to the full breadth of investment opportunities, nor gain the depth of knowledge required to weed out the winners.
And this is perhaps the crux of why China has not been afforded a proportionate role in global asset allocation. The perception that it is highly volatile, too opaque to navigate and the environment too uncertain has deterred many investors. High-profile instances of poor governance and fraudulent book-keeping among even offshore-listed Chinese firms have not helped. Sino-Forest, the infamous failed Chinese timber firm, raised almost $3 billion in Canada’s debt and equity markets before allegations emerged in 2011 that it had fraudulently inflated its assets and earnings. The scandal sent its share price plummeting 82 per cent. Meanwhile, Hong Kong-listed China Huishan Dairy’s share price nosedived by 85 per cent in March 2017, wiping $4 billion from its market capitalisation, amid concerns over excessive leverage and the use of shadow banking4. There are indiscretions across all markets, but the mess from poor governance of failed Chinese companies seems to stain its entire market more than anywhere else.
But there has been a perceptible change as the mainland opens its arms ever wider to foreign inflows. The launch of the Hong Kong-Shanghai Stock Connect programme in November 2014, and the extension to the Shenzhen stock exchange in 2016, removed one of the most significant barriers for international investors - restricted market access. Another development is the science-and-tech focused Star Market - China’s answer to the Nasdaq. It debuted in July and is viewed as China’s attempt to ensure its most innovative companies look to the onshore markets for listing rather than the traditional routes of opting for Hong Kong or the US. MSCI is currently assessing its eligibility for index inclusion ahead of a semi-annual review in November.
The sheer breadth and depth of China’s onshore markets and the relative lack of institutional investors mean Chinese stocks are often under-researched, providing rich stock-picking opportunities for active investors. For passive investors, MSCI’s increasing inclusion of A-shares in its indices means investors can get more meaningful exposure through ETFs, offering another viable option. Capital markets will naturally mature on the back of this. Ultimately, investors who don’t start paying attention to China now risk missing out on the long-term opportunity.
Safety in numbers: focus or diversify?
China retains traits typical of an emerging economy, including restrictions on capital flows, still-maturing markets prone to sentiment-driven volatility and the ever-present prospect of government intervention, alongside the usual macroeconomic and sector-specific risks. China’s debt growth, while on the authorities’ radar, remains problematic and could dampen the prospects for some banks and other financial companies given worries about the implications for liquidity. Meanwhile, the escalating trade tensions between China and the US are causing swings in global risk appetites and have already had an impact on Chinese manufacturers of goods, such as circuit boards, microprocessors, vehicle parts and machinery.
For these reasons, some investors prefer to gain exposure to the mainland via broader emerging market or Asia-focused strategies, as opposed to a pure country fund, since it helps to dilute idiosyncratic risk. Here, an allocation is spread across opportunities within various industries and across multiple countries, either actively selected by experts with in-depth knowledge of each constituent market, or through index-tracking strategies.
Most emerging market funds will provide varying degrees of exposure to China - preferably via a mix of H-shares, US-listed securities, and A-shares - while also capitalising on the growth opportunities across a range of other developing nations at different stages in their economic evolution. Similarly, taking a regional view - via an Asia-Pacific strategy, for instance - would introduce elements of China to a portfolio, but balance it with exposure to some of the less volatile established markets on offer in developed economies of the region. The downside of the broad-brush approach is that it can limit an investor’s ability to tap into China’s growth potential.
Investing for growth
China has become synonymous with growth, for good reason. Its economy may be slowing but it has still expanded by more than 6 per cent a year for over two decades.5 Moreover, the government-mandated pivot towards innovation and technology has cast a spotlight on opportunities across a swathe of industries and sectors, from the internet to robotics to pharmaceuticals. There are many compelling ideas hidden amid the multitude of smaller A-shares, as well as among H-shares and US-listed Chinese firms, particularly in the tech, healthcare and education sectors.
However, investors generally can’t access these opportunities through broader emerging market or regional strategies, which tend to focus on a market’s top 50 or so names and usually those with a broader footprint. More useful vehicles for gaining exposure to companies further down the market cap scale, as well as the more domestically-focused businesses that target the rising wealth of the country’s consumers, are strategies with a pure China focus, backed by solid on-the-ground research.
Consider the sportswear manufacturer Li Ning which challenges global brands like Adidas and Nike through competitive pricing and the ability to adapt nimbly to evolving domestic trends. Loyalty to homegrown brands and products can be a powerful growth driver; particularly so in China considering the vast size of its markets. Liquor-maker Kweichow Moutai derives almost all its sales domestically and benefits from its heritage status as China’s best-known producer of baijiu, the ubiquitous Chinese grain alcohol often quaffed at banquets.
Investing for income
Growth is far from the only game in China. In fixed income, investors can get exposure to a broad and diverse range of Chinese debt through the Asian offshore US dollar bond market, the offshore renminbi (CNH) bond market or the Chinese onshore CNY bond market (although the third is not a market to venture into unguided).
Asia’s liquid offshore bond market blends both the high-spread, high-potential-return attributes of emerging markets with relatively lower volatility. This remains the primary route for exposure to mainland corporate debt and covers the whole gamut of risk/reward profiles, from investment grade all the way through to non-rated high yield.
The market for CNH denominated debt – widely known as dim sum bonds – offers a stepping stone for investors keen for exposure to the currency, but not quite ready or able to take the leap directly into mainland markets. However, the roughly $76 billion dim sum market, centered in Hong Kong, has been shrinking as the onshore market gains a greater foothold.
It’s a work in progress. While China’s onshore government bonds are growing in popularity, due to their decent performance and diversification benefits, corporate bonds remain a trickier sell. Of the roughly $255 billion foreign investors have pumped into onshore debt, only about 8 per cent is invested in debt other than sovereign or quasi-sovereign.6 Additionally, the futures market is still immature, which makes managing interest rate risk both difficult and expensive.
Furthermore, local ratings don’t correspond to international standards. While onshore credit differentiation is improving and risk is gradually being priced more accurately, the lack of diversification in ratings doesn’t reflect the rather sizeable divergence in how companies are managed; about 97 per cent of rated onshore non-financial corporate bonds have ratings of AA or above.7 All of which means foreign investors remain wary and the market somewhat illiquid.
However, it is making headway. In July 2019, S&P released the first rating of a domestic bond by a foreign credit-rating company.8 Meanwhile, similar to equities, index inclusion in widely-tracked bond indices like the Bloomberg Barclays Global Aggregate Index, in which RMB bonds are now the fourth-largest component,9 will further hasten the market’s maturation.
In addition to bonds, the yield on Chinese equities is more attractive than many realise. With an abundance of cash-rich companies, investors could consider the market as a potential source of income. Around 30 per cent of the MSCI China All-share index (including both on and offshore equities) offers a dividend yield of more than 3 per cent.10
Source: Thomson Reuters Datastream, Fidelity International, September 2019. Past performance is not a reliable indicator of future results.
Different eggs in different baskets
Any discussion on the merits of allocating to China wouldn’t be complete without emphasizing its role as a diversifier. One of the key attractions of onshore government bonds, for example, is their almost zero correlation to any other asset, due to different fundamental drivers.
China A-shares, particularly those with a primarily domestic focus, also exhibit low correlations to global assets. While this is likely to become less pronounced over time, as capital flows pick up on the back of rising investor interest, exposure to China remains a decent diversifier in global equity portfolios.
Too big to ignore
To the uninitiated, investing in China might still appear intimidating, despite the compelling statistics. It’s far from a risk-free proposition: wider access to onshore markets has some way to go and potential pitfalls remain.
A conservative approach seems sensible for now. Yet, what happens in China resonates on a global scale - politically, economically and in capital markets. Despite worries over its economic growth and the impact of tariffs, China offers the prospect of lowly correlated returns from an economy that is still opening up its capital markets. And it isn’t going anywhere. Claiming its own prominent seat at the investment allocation table is only a matter of time.
1. World Bank projections 2017 via http://www.businessinsider.com/global-gdp-growth-contributions-chart-2017-6
10. Fidelity International, Thomson Reuters Datastream, June 2018