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Chinese asset markets – time for foreign investors to get serious

(ATF) Isn’t it about time that international investors took Chinese asset markets a little more seriously? On pure GDP terms, it is the second-largest economy in the world, and the Chinese economy has clearly emerged. Only issues to do with the liquidity of its financial markets, the openness of its currency and the need for further reform of its financial markets’ infrastructure holds it back from taking its rightful place as a developed market asset market.

In our view, international investors have yet to come anywhere close to recognising the specific attributes of China’s asset markets to add to portfolio return and diminish risk. We believe that asset allocators will feel a compunction to embrace Chinese assets and to move quickly to give them a larger representation in their portfolios.

Chinese asset markets have two attractive features – underlying good returns and significant risk diversification. In our view, they warrant a far greater weighting in international portfolios in the future.  

International benchmark providers such as MSCI tend to keep moving the goalposts as to what is acceptable for a market to be termed developed or indeed sufficiently emerged. After all, many developed markets today were termed by the index providers as ‘developed’ decades ago when trading was less transparent, less liquid and much less continuous.

If the benchmark owners want to keep China at bay so be it, but for enlightened investors, they may wish to throw off the shackles of benchmark weights and consider a far greater commitment to Chinese asset markets than has been the case in the part. In any case, it is worth noting that the total value of China’s stock market has climbed to more than $10 trillion recently. The market value of US equity markets is by contrast, is at $39 trillion.

Two features of Chinese assets should make them attractive to investors – return and portfolio diversification. 

Ongoing relative strength of China’s economy growth should in turn led to strong corporate profits growth. China, the world’s second largest economy is by IMF estimates set to contribute 26.8% of global growth in 2021 and 27.7% by 2025. China’s growth contribution is forecast to be two-and-a-half times the likely contribution of the US economy. IMF estimates for 2020 put China’s GDP growth at 1.6% while the global economy is set to shrink by 5.2%. 

Asset allocators ordinarily estimate that Chinese companies will on average achieve high single-digit returns in the coming decade as China moves to become the largest economy in the world. By contrast even the optimists struggle to convince that US equities will achieve a total return of much more than 6% per annum over the next 10 years. 

Chinese equities

Studies show that the inclusion of Chinese equities significantly improves the risk/ return characteristics of global equity portfolios. Data for 2001-2018 shows that China’s broad equity market had a correlation of just 0.63% versus the United States. The A-share index of mainland stocks had a correlation of only 0.30% versus the United States, and similarly low numbers versus other major developed countries.

Even in the past 12 months when global events have naturally driven correlations between market higher, the Chinese A share market maintained a relatively low correlation with US equities of 0.55 and 0.6 with Global equities (Table 2). 

A study by JPMorgan Asset Management (Understanding the opportunity in Chinese equities Michael Hood, et al) concluded that “allocating to Chinese A-shares, mirroring the All Country World Index’s likely future allocation to China should significantly add to returns without increasing risk. 

Studies show that international equity investors own around 5% of the Chinese equity market. Many international investors tend to be benchmark huggers. However, given the asset class characteristics of Chinese equities outlined earlier we expect more international investors to stretch their mandates to holding a consistent and more sizeable specific position in Chinese equities well above benchmark weightings.

More enlightened equity investors are targeting around a 5% allocation in their all country weightings to Chinese equities. Most investors have considerably lower weightings with many still at zero. A year ago, foreigners owned a mere $253 billion of Chinese equities, equivalent to less than the likely size of Ant financial when it IPOs and less than 1% of the size of the US equity market.

Chinese Bonds

Like Chinese equities, Chinese bonds offer significant diversification benefits for international investors. In a SSGA research note Chinese bonds the case for an increased allocation” (Michele Barlow and Yichan Shu) the researchers show that in a simple portfolio optimisation using Global Aggregate USD Unhedged index and Bloomberg Barclays China Treasury and Policy Bank USD unhedged index, the optimal portfolio mix is around 50% in each asset class. They conclude that “investors should consider making a meaningful allocation to Chinese bonds”. 

Key to the diversification benefits of Chinese bonds are the relatively low correlations between Chinese bond indices and major regional developed market bond markets.

There are signs that global investors are turning to the Chinese bond market in increasing numbers. CSOP asset management estimate that foreign ownership of Chinese government bonds has quadrupled to more than $400 billion since 2015. ICBC CSOP FTSE recently launched a Chinese government bond Index ETF which had raised an extraordinary $680 million.

The latest data from the Institute of International Finance puts foreign ownership of the Chinese bond market at less than 5%. Even in emerging economies such as Indonesia, Malaysia, Mexico or South Africa 20% foreign ownership is not unheard of. In a world where investors are desperately searching for yield, Chinese government 10-year bonds offering a yield of 2.5% contrasts with a US 10-year government bond of yield of 0.7%. 

Of course, there are risks for international investors to consider. Trade wars between the US and China have put hurdles to free and open trade and portfolio flows. Earlier this year the US State Department warned US college pension funds not to invest in Chinese stocks. 

However recent years have been marked by much US government rhetoric about action to limit investment in Chinese asset markets when the reality was something much tamer. For example, the US authorities have been encouraging the delisting of Chinese entities from the US markets, however at a time when US investment banks are trying to rapidly expand their footprint in China.

Also, in reality the number of Chinese company listings has been over twice that seen in President Obama’s last term and only half the levels of de-listings. 

# Gary Dugan, The Global CIO Office, Singapore October 2020.

AF China Bond