As investing in China's domestic stock market becomes increasingly mainstream for a wide range of global fund managers, investors are increasingly assessing their asset allocation to the world's second largest economy.
For many years, global investors have largely avoided direct exposure to China's domestic stock market. There is a longstanding belief that the exchanges in Shanghai and Shenzhen are difficult to access, and they are markets that are best left to specialists. This idea is increasingly out of date.
The success of the Stock Connect programmes and the inclusion of China A Shares into MSCI Emerging Markets Index means that asset allocation into China is a viable investment strategy for a very wide range of fund managers. Investors that continue to ignore the world's second economy could miss out on some of the most interesting investment opportunities in the years to come.
Asset allocation considerations relating to China were the theme of a panel discussion at HSBC's 2018 China Conference, where investors emphasised the need to take a long-term approach to the Chinese market.
The members of the panels have a time horizon towards China investment that can be measured in decades. Individual sectors might become more or less attractive over time, but on a country level there are few markets that have such a broad range of positive factors – urbanisation, a high savings rates, pension reform, as well as policies to rebalance the economy towards to the consumer.
From a shorter-term perspective, there is already a positive shift in the attitude towards China, which the panel attributed to the global investment community becoming more comfortable with Beijing's reform agenda for the country's financial system. Furthermore, the global backdrop has bolstered China's standing among investors, as the world economy is currently in an environment of synchronized growth, with China making a major contribution.
A factor approach to asset allocation
China is a unique market with many idiosyncratic qualities – from the processes that govern market access and trading to the range of companies listed on its exchanges.
The panel highlighted the need for investors to make a distinction between China's state-owned enterprises and its privately-run companies. The main reason is related to performance, as private companies have produced much higher returns than the state-owned sector over the last decade.
Focusing on other market factors can also be an effective strategy in China, which is typically considered to be a momentum market driven by retail investors. But when the market's returns are decomposed into its components – value, growth, earnings, and momentum – value actually emerges as a significant explanatory factor for Chinese market performance.
Following a value-based strategy has worked historically in China, which is counter to how many people think about the market. The factor-based approach is therefore highly relevant to China, even though it is often overlooked.
Understanding the headwinds
Even though China continues to post strong growth figures, there are widespread concerns among international investors that the world's second largest economy could stall in the coming years. Such fears are another reason that the global investment community tends to underweight China. For investors already in the market, these concerns could affect how they distribute capital among different sectors.
The most recent headlines to cause concern relate to the fear of a trade war with the US, which could not only damage Chinese exports, but also disrupt the global trade cycle. The negative impact on the economy could filter through to local equities – such as companies that have an exposure to US exports.
The panel said that a negative attitude towards China is now an ever-present part of US politics. But it comes at a time when China is engaging in deep structural reform that is pro-business in nature, which could help avert a full-blown trade war.
The takeaway from the discussion was that trade issues between the US and China will not disappear overnight. Another concern that has weighed on investors in recent years is China's rising debt levels, as local governments and corporates have loaded their balance sheets with debt over the last decade, reaching levels that some investors consider unsustainable. In addition to the broad economic impact that excessive debt could have, it raises sector-specific fears – most notably on China's huge banking sector.
The panel highlighted a series of steps the government is taking to ensure that China's debt burden does not get out of control. The banks are recognising more bad debt, with non-performing loans being reported by commercial banks. Debt for equity swaps and supply-side reform are two more methods that could help companies struggling with debt. More broadly, growing the economy will make repaying the debt of previous years much easier.
The long-term solution to China's debt issue could lie in the development of another part of the country's financial system. The growth of the bond market means that the banks are not the only source of credit for corporates and local government, and the investors who provide the funding will use more commercial considerations when providing money to borrowers.
For that to happen, the main thing that needs to change is the level of defaults, which were historically non-existent in the local bond market. In a market where companies are not allowed to fail, capital is inefficiently allocated, and investors do not take on risk when they buy into the market. So in order for China to get a fully-functional bond market, defaults must become a real possibility, said the panel.