The models are broken
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Chief Investment Officer
Since China commenced on the path to economic reform in 1978, it has ensured its current position as one of the largest developing countries in the world with remarkable speed. The emerging stock market has experienced tremendous growth since the inception of the Shanghai and Shenzhen’s stock exchanges at the beginning of the 1990s. Essentially non-existent prior to December 1990, they have grown to become the second-largest in the world behind the US, totalling over $12 trillion in market capitalisation as of the end of 2017. At the same time, recent changes to restrictions on foreign investment have provided offshore investors with new access to China’s domestic stock markets and it is anticipated that China’s stock market will still develop swiftly in the future and will play a vital role in world markets.
China has delineated its plans to become a world superpower within the next 30 years, and to overtake the US. President Xi Jinping, speaking at the National Congress late last year, said it was time for China to become “a mighty force” that would lead the world on political, economic, military and environmental issues:
“The Chinese nation…has stood up, grown rich, and become strong – and it now embraces the brilliant prospects of rejuvenation. It will be an era that sees China moving closer to center stage and making greater contributions to mankind.”
As well as evolving into a rising global power China’s capital markets are evolving at great pace, there are major changes taking place in the Chinese stock market that could significantly impact investors. As Chinese capital markets are opened, global investors can participate in what will arguably be the most transformational century as China accelerates growth through productivity, focus on innovation and R&D under “Chinese Characteristics”. Chinese companies overtook Japan last year as the world’s second largest filers of patents according to the World Intellectual Property Organization. On current trends it will overtake the US within three years. Any investor who is underweight China in the coming years will significantly underperform global equity indices especially as Chinese equities are included more meaningfully in global indices after years of under-representation.
China is on a rapid path of change, and has already advanced more than the western world gives it credit for. The One Belt One Road, Made in China 2025 and Shanghai Cooperation Organisation initiatives all are representative of the growing importance of China ion the world stage. As President Trump makes the US an unreliable partner in globalisation, China is poised to pick up the slack with the One Belt One Road becoming a new venue for multi-lateral trade.
As Xi ramps up China’s imperial ambitions, in contrast, the US deficit deteriorates and the US follows an inward looking “America First” policy. This important trend will reshape geopolitical paradigms and the world order in a way that few have yet registered, providing global recognition for China’s financial markets and a greater international role for its currency. The real war will not be a Sino-US war over trade or technology but a struggle for dominance between the US dollar and the renminbi.
Changes in China’s capital markets
China is allowing increased foreign access to its financial markets in a bid to prove commitment to openness and liberalisation of its economy. The daily quota on the Hong Kong-Shanghai and Hong Kong-Shenzhen Stock Connect was quadrupled from May 1 2018. China's new central bank chief, Yi Gang, also publicised plans to remove limits on foreign ownership in the financial industry, ratifying China’s commitment to greater openness and access to the Chinese economy. Furthermore, speaking at the Lujiazui Forum on June 14, 2018, Peoples Bank of China governor Yi Gang, strengthened claims of commitment to yuan internationalisation, capital account convertibility and sustainable growth. A key takeaway from the forum was to put in to place an initiative, or “glorious mission” in Li Qiang’s word’s, to make Shanghai a global financial center with possible scope for expanding the range of foreign financial companies business, indicating an acceleration of “opening up” mandate.
The Stock Connect is already integrating Hong Kong, Shanghai, and Shenzhen, and has paved the way for MSCI’s decision to add 226 yuan denominated, locally listed Chinese companies to its MSCI Emerging Market Index on June 1, 2018. The inclusion in the MSCI EM Index puts A-shares on the global stage as an investable market. MSCI has signaled that China’s regulatory environment, liquidity environment and accounting principles are satisfactory for investors. Another attestation to the integration of China’s financial markets into international finance came in 2016 as the renminbi was included in the International Monetary Fund’s special drawing rights basket, making the renminbi part of global reserve currencies.
What is Stock Connect?
Stock Connect represents an opportunity to invest in China’s growing economy. This link between the Shanghai Stock Exchange and the Stock Exchange of Hong Kong, introduced in 2014, expands the connection between the mainland Chinese stock market and the rest of the world. In late 2016, the establishment of a similar link between the Shenzhen Stock Exchange and the Stock Exchange of Hong Kong marks the latest step.
The result has been a flood of opportunities for investors and companies inside and outside of China. The two cross-border schemes were major milestones in China’s efforts to open its markets. They allow international investors to trade A-shares listed in Shanghai or Shenzhen via any brokers licensed by HKEX, while providing mainlanders with a means to trade Hong Kong-listed stocks.
Shares listed on the Shanghai and Shenzhen stock exchanges will be available on Saxo Platforms through the Stock Connect programme from June 19, 2018.
This comes at an opportune moment as the China Securities Regulatory Commission has increased the daily quota of mainland China-listed shares that can be bought in Hong Kong via the Stock Connect channel to Rmb52bn ($8.3bn) from Rmb13bn. Additionally, the CSRC has said it will increase the amount of money that can flow Southbound thorough Stock Connect, by quadrupling the daily amount of Hong Kong-listed shares that investors can buy through mainland Chinese stock exchanges.
This combined “China” stock market ranks as one of the world’s largest. Combined market cap – $12.45 trillion.
Creating a global leader
The Stock Connect programmes create a single “China” stock market that ranks as one of the biggest in the world by market cap and daily trading turnover.
• Market cap of NYSE – $24.6 trillion
• Combined market cap of HK, Shanghai and Shenzhen – $12.45 trillion
• Market cap of Nasdaq – $10.84 trillion
MSCI addition and how this affects A-shares market
On June 20, 2017 MSCI announced the partial inclusion of China A-shares in the MSCI China Index, the MSCI Emerging Markets Index, and the MSCI ACWI Index. The MSCI Emerging Markets benchmark is tracked by $1.7 trillion of institutional funds globally, predominantly through passive allocation. This is highly representative of China finally obtaining the long desired global recognition of its financial markets.
The MSCI inclusion of more than 226 mainland China A-shares welcomed China to the world stage. The addition will significantly increase global investment into mainland Chinese equities as passive inflows of up to $6.5 billion could be seen purely from portfolio adjustments to avoid deviations from the MSCI EM benchmark index. Furthermore, the active allocation should generate far greater inflows, likely to be more than $20 billion as institutional investors will have more confidence in the mainland equity market which is growing approximately twice as fast as the US. This is not likely to render a material change to the current trading style and movement trend of the A-share market considering the daily market turnover of $50-$100 billion. Though there is not a substantial impact in the short term, the inclusion is more of symbolic significance.
Throughout April 2018, the Northbound flow was the highest since the Stock Connect's inception, and this could be credited to foreign investors increasing allocations of Chinese stocks before the MSCI inclusion which went ahead on June 1 2018. Some of the top stocks traded Northbound are liquor giant Kweichow Moutai, Ping An Insurance and Gree Electric Appliances. Given the modest initial weights and the lack of clarity on future increases, it is doubtful that index-driven flows will drive share prices meaningfully higher. For this reason, it is not recommended that investors use MSCI’s inclusion as the driver of any decision on whether to overweight this market. Rather, the upside potential of selected A-shares, given robust construction, industrial activity and profit growth alongside a growing middle class and urbanisation driving a spending boom.
Shanghai/Shenzhen listed stocks with highest daily turnover through the stock connect:
Future A-shares developments
Based on the 2.5% Index Inclusion Factor (IIF) which will rise to 5% in September, the A-shares will account for a modest 0.73% of the MSCI Emerging Markets Index. This is much less than the A-shares' representation in emerging markets by market cap and turnover.
Lifting the index inclusion factor from 5% to full inclusion would raise China A-share weightings to 15% of the MSCI EM Index. With index adjustments relaxed over the medium term through expected policy change, a heavier weighted value-add should be seen towards direct general China investment and exposure to mid-cap Chinese equities. This would be achieved through greater alignment with international market accessibility standards, the resilience of the Stock Connect programme, further relaxation of daily trading limits, continued progress on trading suspensions and further loosening of restrictions on the creation of index linked investment vehicles. The timing of this will come down to the motivation of policymakers in China and the overall demand of consumers for the MSCI to increase the China weighting. Furthermore, following MSCI’s addition, as confidence in China’s capital markets strengthens, other index providers such as FTSE Russell will likely follow suit. This is not a matter of if, but when.
Given the above, A-shares should weight above 15% in MSCI, probably in 5-10 years as at this point overseas capital would have more prominent effect on A-shares as inclusion increases. As the inclusion rate for these stocks increases, more A-shares will be included. Thus, we would expect to see greater foreign focus on A-shares from institutional investors who have a healthy investment process as opposed to the more speculative nature of A-share retail participants. A-shares companies with strong business models, suitable corporate governance and robust balance sheets will likely see the most foreign interest, but as investors gain more confidence in investing in A-shares we could see a shift down the market-cap curve where the companies are generally less well covered.
Overall, the addition of the China A -shares to the MSCI EM Index is symbolic of China’s increased liberalisation of its financial markets and represents a new era where China is a true player in global markets as institutional investors globally gain confidence in the country's markets.
Secular growth themes/stocks to watch
Share prices in the A-share market have come to a reasonable level after fluctuations over the past few months, the CSI 300 is currently trading below historical average easing valuation concerns and pricing in short-term risks. Solid fundamentals, robust earnings, and a supportive macro backdrop should contribute to upside potential over the coming months.
Demographic shifts and a burgeoning economy has unleashed a wave of consumer spending in China and this will continue in the coming years. China has a similar proportion of city dwellers as the US did in 1940, moreover, between 2009 and 2030, the country will add 850 million to its middle class (OECD Working Paper, Dr Homi Kharas). This means the Chinese middle class will grow from 12 percent of its population in 2009 to 73 percent in 2030, firing up demand for jobs, educations, apartments, and services and boosting purchasing power. Kharas’ definition of middle class defines household income equivalent to between $US16,000 and $US160,000 per year, a widely used definition. This illustrates there are still decades of above-average growth and urbanisation to come and confirms China's potential re-emergence as the world's biggest economy. Increasing incomes and rising living standards are promoting lifestyle changes causing an industry rotation out of industrials to consumer-centric industries.
With the rise of the middle class, consumption may continue to contribute most of China's GDP growth in the coming years. Income growth and urbanisation will upgrade Chinese consumer’s high end consumption. Another secular growth theme could come from China’s lower tier cities as they become larger and wealthier and start injecting further consumption potential and vibrancy into the economy, thus stimulating the stock market in the long term. Sectors such as telecom services, infrastructure, consumer staples and the large state banks should benefit from these secular growth themes and outperform through any correction.
China’s GDP by industry % (below) – Shifting economic policy is delivering a new service-based economy where consumer spending will potentially contribute more to further GDP growth.
The growth and decline in industry weights of the A-shares market
The best defence is a good offence in today’s market. High-quality companies, running at lower leverage (with credit spreads slowly widening), offering good growth potential will be the safest bets. As always, successful equity investment comes from identifying companies which can generate above average returns on the capital shareholders have invested. In the A-shares market, selecting companies with strong business models, healthy corporate governance and robust balance sheets not laden with debt will help to fulfil the aforementioned condition.
Whilst there is no doubt China’s importance in global markets is increasing, from an equity investor’s perspective gaining exposure to Chinese shares is not as straightforward as some may tout. As the economy develops as outlined above public companies in the consumption sector with a global vision and higher level of automation, e-commerce companies, high-end manufacturing companies, and healthcare companies could all be good picks for investors to find tomorrow’s consumer winners in China. Among all sectors the steadiest growth is likely to come from healthcare and consumer, within the consumer sector overweighting names that ride the consumption upgrade into premium level.
Food and beverages
Kweichow Moutai, China’s biggest liquor maker, sells high end spirits for more than $300 a bottle and has recently hit Aussie stores. The liquor giants market cap topped 1 trillion yuan on Tuesday (12 June, 2018). Moutai’s earnings could surge 21% in 2018-2021 on demand from China’s growing middle class and limited supply.
Other distillers Wuliangye Yibin Co and Jiangsu Yanghe Brewery Co. will also benefit from a growing middle class and a lifestyle shift to high end consumption. Others in this category are the pork breeder Muyuan Foodstuff Co. and the dairy producer Yili Industrial Group Co.
Midea Group manufactures, markets and installs household electric appliances, compressors and components. Midea is likely to gain more market share in China for its appliances, with the recent acquisition of Germany’s Kuka giving it a strong position in the robotics industry.
China Vanke operates a real estate development business, providing renovation services, loans, and material supplies. Following the recent correction, the valuation has become more attractive. Earnings grew 29% in the first quarter of this year and this momentum should continue as sales increase. A key risk is the recent rise in net gearing due to land capex.
The Chinese healthcare industry is expected to grow more than 20 percent annually for the coming three years as China’s burgeoning middle class ages and becomes wealthier. This is feeding into outsize gains across the entire Chinese healthcare sector as it outperforms the CSI 300 Index. Drug makers in China are sheltered from a US trade war because they generate most of their sales domestically. Mainland investors have found refuge from the looming threat of a US/China trade war in healthcare companies like Jiangsu Hengrui Medicine, the biggest drug maker by market value, and Zhangzhou Pientzhang Pharmaceutical, a traditional medicine supplier, as their shares have more than doubled in the last year. Other names include Huadong Medicine - manufacturer of antibiotics, Tasly Pharmaceutical Group - traditional Chinese remedies, Guangzhou Baiyunshan Pharmaceutical – China’s Viagra.
China is a country that has welcomed digital surveillance wholeheartedly. According to Morgan Stanley research 400 million security cameras will be added by 2020 (Source: Morgan Stanley), this would make Hangzhou Hikvision Digital Technology a top pick for exposure to this field.
China's auto industry is accelerating towards a smarter and cleaner vision. China plans to increase new energy car sales and throughout 2014-17 the sales grew over 100% thanks to various government policy supports (Source Bloomberg). This trend is expected to continue as the government only subsidises pure battery electric vehicles. Jiangxi Ganfeng Lithium manufactures electric vehicle battery components, as well as Zhejiang Huayou Cobalt Co. and would be beneficiaries of increasing demand for new energy vehicles riding the official government policy wave.
Ping An Bank could benefit from a boom in consumer lending. Ping An Insurance’s fintech push will help it gain market share, justifying higher valuations relative to peers.
As salaries increase, domestic and international travel spending should rise in tandem. China International Travel Service a travel, duty free shopping and real estate company, Shenzhen Airport and GZ Baiyun Airport would all profit from this secular growth theme.
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Chief Investment Officer
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