Market thinking

Why agility is key to navigating China’s equity market

Investing in emerging market assets brings with it various distinctive risks. When it comes to China, the country’s scale and political system give investors perhaps more issues to weigh up than almost anywhere else when making an allocation decision.

Between managing risk and liquidity, to addressing ongoing volatility and uncertainty in terms of markets and policies, an active approach seems essential.

Managing China’s idiosyncratic risks

We manage risk in our China equity strategy through several tactics. For instance, we cap the weighting for any position we hold in the strategy to protect investors from benchmark concentration risk.

More broadly, understanding the priorities of policymakers is particularly important in China. We therefore constantly assess policy initiatives and their potential implications for various sectors and industries. We then try to identify the companies that could potentially benefit from these changes.

Ultimately, alpha – in our experience – can come from anticipating these policy/paradigm changes. Hence, precisely because of this idiosyncratic risk, actively-managed China funds on average have consistently outperformed the benchmark. 

The Morningstar data below (Exhibit 1) looks at all China equity funds and shows an average return that outperforms the index across most of the periods sampled, and with lower volatility.

In our opinion, the investment process we apply to our thematic equity strategies has also shown an effective ability of identifying potential structural growth stories and filtering out names that are more likely to underperform.

Exhibit 1: Performance of MSCI China Index vs. Average of all China Equity funds (net of fees)

A-share liquidity

The A-share market is very liquid as both Shanghai and Shenzhen stock exchanges are ranked within the top 10 in the world by market capitalisation[1]. However, liquidity stress surfaced in 2015 when half of the stocks were suspended from trading due to market correction[2].  MSCI flagged this issue as one of the arguments against the inclusion of A-shares into the MSCI Emerging Markets Index initially[3].

However, China has made significant progress in recent years. Since 2016, China’s stock exchanges have increased the hurdles for listed companies to suspend trading, both on the conditions to apply for a suspension and on the length of the suspension period.

We have seen significant improvements since these new regulations were implemented (Exhibit 2).  And we expect to see further improvements in this area as China continues to reform and liberalise its financial markets.

Exhibit 2: Number of suspensions in A-share market reduced in recent years

Volatility of Chinese A-shares

The perception of domestic A-shares typically is that they are volatile.  Despite what some people think, the high retail ownership ratio is not the main issue; instead it is due to its relatively high representation in daily trading volumes due to short holding period by retail investors. That said, a recent Tencent report[4] concluded that the retail investor base is getting more educated and sophisticated, which is a good sign for the market’s evolution. More specifically, if we look at the volatility of the CSI 300 Index over the past decade, it averages around 22%. Today, we are below that, at around 20%[5].

There is also a clear trend of ‘institutionalisation’ of the domestic equity market away from retail. The below chart (Exhibit 3), for example, shows that as of last year, financial institutions comprised nearly one-quarter of the investor base for A-shares, up from only 10% in 2007.

Exhibit 3: Institutional investors share is growing in China

Source: Bloomberg, Shenzhen SE, BofA Securities
 

As the domestic market continues to develop, with increasing participation by both foreign and local institutional investors, there is certainly scope for the average volatility to trend lower.

The currency challenge

There is no doubt that the level of the US dollar and the interest rate environment are important considerations for emerging market equities as a whole, and Chinese equities are no exception. Notably, China started to peg the renminbi to a basket of currencies just over five years ago, with the goal of creating more currency stability[6].  Still, it would be a mistake to generalise the impact of currency movement on the operations of companies.  

In our experience, Chinese companies typically hedge their exposure if they have a good visibility on what that exposure will be. Where possible, they might also try to localise operations to better match cost against revenue. Further, most companies that import raw materials will manage this risk through inventory management and hedging.

A weaker renminbi is a positive for some companies. Historically, in periods of renminbi depreciation, we have seen consumers spend more domestically as they do less traveling overseas or buying fewer imported goods. The resulting import substitution effect tends to be positive for many domestically-oriented themes.

However, in line with our approach to actively manage investments in China, we analyse trends in the renminbi to assess when it could potentially have a material impact on companies we monitor. While it is complicated and challenging to hedge in the short term, we believe that the currency impact is of lesser importance than the company fundamentals over the long term.

We believe the renminbi will remain stable in 2021. Yet with other countries resuming production activities and vaccines being rolled out, China’s trade surplus may decrease, and the US/China interest rate spread may narrow. These trends might limit the renminbi’s upward trend. Our economists expect the US dollar/renminbi rate to range from 6.4 to 6.5 this year.

Opportunities in China’s long-term development plans

Having lived and travelled extensively through China, I have seen the country’s levels of pollution first-hand. There were days where I could not see 10 feet ahead of me while walking down the street.

China today is a very difference place. China produces 70% of the world’s solar modules, 73% of lithium battery cells, almost half of the world’s wind turbines, and 30% to 40% of all the electric vehicles[7]. It has become an extremely credible player in clean technology, and it makes sense that China will need to continue to invest, to retain this leadership.           

Another area I find very exciting is the healthcare sector. While ageing populations is a global issue, it is perhaps the most important structural challenge facing China, because it has gone through four decades of the One Child Policy, and currently it is amongst one of the fastest and largest ageing population in the world. The elderly population is estimated to peak at close to half a billion people by 2050. We believe there are a lot of opportunities here including healthcare and silver spending.

At the same time, the pandemic has sped up the pace of digital transformation – a trend that was already on the way before COVID-19. China’s ability to continue to access leading edge semiconductor chips is crucial for the country to climb up the technology curve and achieve self-sufficiency. Investments into research and development will likely continue and import substitution will likely accelerate.

In addition, we are finding more opportunities in the enablers of the digital economy. An example is the cloud computing space where we are seeing a clear shift from private to public cloud. The public cloud market in China is currently about a sixth of the size of that in the US, so we believe there is more room for growth.      

Asset allocation of overseas investors

These trends will have been noted by investors outside of China as well, which has implications for asset allocation. The inclusion of A-shares into the MSCI Emerging Markets Index in 2018 was a huge first step for Chinese onshore equities stepping into the international arena (Exhibit 4). Currently, China’s total weighting in the MSCI All Country World Index is 5.3%. Of the 653 Chinese constituents, 467 are A-shares, with this group accounting for just 0.65% (roughly 13% of China’s current weighting).[8]

Exhibit 4: Development of China’s weighting in MSCI’s Emerging Markets index since before A-share inclusion in 2018

While it’s difficult to specify a fair weighting for China in the MSCI All Country World Index, we can compare it with Japan, whose weighting is 6.8%. Given that China’s GDP is 1.8 times that of Japan, plus the former is growing faster, it is plausible we will see China’s weighting rise to 8% to 10% of global equities over the next decade. Also, China already accounts for 15% of global market capitalisation and for 17% of global GDP[9].

MSCI conducts four routine reviews per year; however, the evaluation of China’s A-shares’ further inclusion and constituencies could happen at any time. Before then, Chinese regulators need to address concerns within MSCI in areas such as hedging instruments, settlement cycle, and banking holiday and trading alignment.

We expect these issues will be addressed over time. For example, the omnibus trading issue (enabling trading for multiple clients’ accounts through a single order) is being worked on at the moment, with a solution possible by mid-2021.

Based on these reasons, we expect to see continued growth in China equity allocation by overseas investors.

[1] https://www.kieconomics.com/ranking-of-stock-exchanges-in-the-world-2020/

[2] https://www.ft.com/content/1bf693dc-24f9-11e5-9c4e-a775d2b173ca

[3] https://www.msci.com/documents/1296102/ffd4f403-40c8-4821-a521-d74d7e4e1127

[4] https://finance.china.com/stock/13003071/20210114/37248348.html

[5] Source: Bloomberg, MSCNAL HVG, as of Jan 15, 2021

[6] https://www.nytimes.com/2015/12/12/business/international/china-to-track-renminbi-based-on-basket-of-currencies.html

[7] China Solar Glass” – CLSA (7/20/2020); https://www.globalxetfs.com.hk/research/wind_turbine_manufacturing_ecosystem/; BNEF, Mar 2020; https://www.virta.global/global-electric-vehicle-market

[8] Source: Bloomberg, as of 2/3/2021

[9] https://www.globaltimes.cn/page/202102/1216746.shtml

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