Investors fixated on China's macro issues could miss the bottom-up opportunities in a market with more listed companies than the US, says our Asia-Pacific equities CIO. Rewards abound for investors who grasp the size and subtleties of fast-changing China.
A bottom-up story
When many investors think about China today, they focus on a few well-publicized macroeconomic concerns: property bubbles, non-performing loans in the banking system or the renminbi's weakness against the US dollar. In our view, these are all valid issues, but we see investing in China as more of a bottom-up story— one that can reward active investors who understand the size and subtleties of a booming marketplace.
We see investing in China as a bottom-up story that can reward active investors
Consider that there are now more than 4,200 Chinese companies listed on stock exchanges around the world mostly in Shanghai, Shenzhen, Hong Kong and the US— with a total market-capitalization size of $10 trillion. That means there are more listed companies in China than in the US. As in the US, the sheer size of this group means there are always promising companies to be found. But unlike in the US, many inefficiencies still exist in China’s equity markets— and it is here where active managers have an opportunity to deliver alpha to investors.
With a total market-cap of $10 trillion, China has more listed companies than the US
Shanghai vs. Shenzhen
For example, China's equity markets— A-shares, H-shares and American Depositary Receipts (ADRs)— behave quite differently. The Shanghai and Shenzhen markets in particular are influenced more by local factors particular to their business climates: Shanghai is more represented by old-economy sectors, such as financials, while Shenzhen is dominated more by new-economy sectors, such as technology. Meanwhile, H-shares and ADRs are more influenced by overseas sentiment on China. This enables astute active managers who are focused on fundamentals to exploit these differences and add another source of alpha potential.
Many inefficiencies exist in China’s equity markets—which is where active managers can find alpha
With new reforms opening up China's already massive equity and bond markets to outsiders, it may need to be considered an asset class in its own right. William Russell says its high time investors rethink how they go about accessing the region.
By William Russell
China in transition
For investors, China can be a polarizing subject. A few years ago, many believed the country would play a crucial role in pulling the global economy out of the great financial crisis, and that China's growing economic power would be the most compelling investment story of the 21st century. For other investors, the extreme market volatility of recent years has given rise to growing concerns about the credit-fueled nature of China's economic development, and worries about whether China will successfully make its much-needed "rebalancing" transition to a different type of growth model.
China's capital markets are becoming significantly more important to the global financial system
But whether you're a China bull or a China bear, China's capital markets will likely become significantly more important to the global financial system in the coming years. And as China's capital markets become truly accessible to global investors for the first time, investors may need to rethink the way they will access China in the future.
A major market underrepresented in indexes
As befits the second-largest economy in the world, China's capital markets are large and deep. There are, for example, more listed stocks in China's equity markets than in the US. China's equity-market capitalization of close to $10 trillion accounts for around 18% of the world's total— almost double the market-cap size of Europe. Moreover, China's bond markets are the third-largest in the world, measured by total bonds outstanding.
With 18% of the world's total market cap, China's stock market is almost twice the size of Europe's
But of course, most global investors' portfolios look very different: Their allocations do not match the markets' allocations because of the mismatch between market-cap size and index weightings. For example, contrast China's aforementioned 18% of the world's market-cap size with its 3% share of the MSCI All Country World Index. This mismatch is not new; China has been under-represented in global indexes for many years. But there are growing signs that the obstacles to this— especially the fact that China's onshore capital markets are not included in global benchmarks— are coming down as investor access improves.
China has been under-represented in global indexes for many years; it's only 3% of the MSCI ACWI
Increasing attention from international investors
In recent years, through bull and bear markets, the pace of China's financial-sector reform has picked up markedly. A municipal-bond market has been launched, currency-trading limits have been increased and China's currency has been included in the International Monetary Fund basket of "special drawing rights" currencies— to name a few. All told, these reforms issue a very clear signal: China is moving toward closer integration into global financial markets, and in doing so it is slowly opening up its own markets to international investors.
For equity investors, the launch of the Shanghai and Shenzhen Stock Connect schemes—in 2014 and 2016, respectively— meant that for the first time it was possible to access China A-shares without using cumbersome Qualified Foreign Institutional Investor quotas. Indeed, through Stock Connect, more than 90 of the stocks in the MSCI China A Index can now be bought directly.
Barriers to inclusion coming down
There are two broad implications from investors having greater access to China's markets. The first is that for China A-shares, the barriers to inclusion in global indexes are coming down. It is highly likely that China's representation in both equity and bond indexes will increase potentially significantly in the next three to five years. This does not mean there is a "wall" of foreign capital that will induce a strong market rally, but it does mean that investors will no longer be able to ignore China's A-share markets.
Greater access means fewer barriers to inclusion in global indexes, and less focus on onshore vs. offshore markets
The second implication is that the way investors will look to access China equites is likely to change. No longer will there be the clear distinction between offshore H-share-dominated portfolios, and separate A-share portfolios. Over time, it will become increasingly possible to select from "the whole of China" as offshore and onshore markets converge, building portfolios with one's highest-conviction stock ideas regardless of which stock market they are listed in.
We believe it's clear that China is increasingly moving toward being considered a separate asset class in its own right. This, in time, will lead to greater investor focus on China and an increased focus by asset managers to develop new solutions that meet their clients' evolving needs.
China's Stock Market: 2nd Largest by Market Cap
Key stock markets as a percentage of world's total stock market capitalization
Source: World Bank, Allianz Global Investors, as of December 2015.
*China refers to China A-shares and Hong Kong-listed stocks.