China’s Dynamic Place in a Global Portfolio
January 8, 2018
Vice President & Investment Strategist, International Business China Asset Management Co.
Investment Director, Equities
Opportunities and risks in Chinese equity
Many investors believe Chinese equity is one of the most important investment opportunities of a generation, but others remain skeptical.
High degrees of investment risk, low (yet increasing) levels of transparency and a general unfamiliarity with local opportunities in China often leave some investors waiting on the sidelines while the growth opportunity passes by. While the risks of investing in China are real, the opportunities for growth for Chinese companies – locally in China and offshore, globally – are broad-based and encouraging.
Equity returns for Chinese companies have been considerable over the past 12 years or so. Since January 2005, Chinese equity returns, both local and offshore, have outpaced developed and Emerging Market returns, albeit for substantially higher risk3 (see Figure 1). Given China’s more extreme risk-return profile than we have experienced in the developed world, one might ask whether it is beneficial for investors to invest in Chinese equity on a risk-adjusted basis. While each investor must determine what investments are right for them, according to their risk tolerance, investors with a lot of US or Canadian equity exposure in their portfolio would have benefited from consistently lower correlations in Chinese equity versus Canadian and US equity. This leads to a higher diversification benefit (Figure 2). So, while exposure to Chinese equity can look extreme from a risk-return perspective, the diversification in the portfolio mitigates that to a certain degree, and risk-adjusted returns may actually improve.
Economic and Market Overview
At approximately C$14 trillion, China’s GDP is second only to the US and the country is the largest emerging market in the world. China is also transitioning from the “World’s Manufacturer” to a more internally sustainable economy. The rise in per capita income and the associated domestic demand for more and better goods and services are reducing the country’s reliance on exports. As of 2016, the service sector contributed 51.2% of China’s GDP and 59.1% of its GDP growth (Figure 3). The Chinese economy is expected to grow at rates between 5.0% and 6.5% for an extended period of time, far above the target 2.0% of GDP growth rate in developed countries.
Chinese equity markets are also reasonably priced when compared with peers in developed markets. In 2017, the Chinese onshore A-share market delivered returns of more than 15%. That performance was driven by an improvement in company profitability and fundamentals. The CSI 300 Index is a capitalizationweighted stock market index designed to replicate the performance of top 300 stocks traded in the Shanghai and Shenzhen stock exchanges. As of August 2017, the CSI 300 market was attractively valued at around 15.0x P/E, lower than the 18.8x of the S&P/TSX Composite Index and 24.0x of the S&P 500 (Figure 4).
China’s economy developed as its industrial revolution and internet revolution occurred at the same time. The compounding effect and new wealth generated by the two revolutions provide exciting investment opportunities. In 2016 and 2017, a transition started where companies’ market positions solidified and market leaders will have the cash flow and capabilities to further consolidate the market. Price competition for low value-add products and services will intensify and companies will face pressure to differentiate and move further up the value chain. This would make the market more reflective of the economic fundamentals in China. We believe the following investment opportunities will continue over the next few years as these sectors are positioned for sustainable growth.
Chinese household discretionary spending is rising to improve the quality of life of citizens. In 2016, urban households spent more than $2,000 USD in food, alcohol and beverages, clothing and healthcare4. This represents a five-fold increase compared to 20 years ago. Chinese consumers are transitioning from “having” to “having more” and “having better”. As a result, companies with strong brand premiums, differentiated products and longterm competitive advantages tend to outperform the market. As the Chinese are earning more, we expect the appetite for further upgrades. For example, automobile ownership in China is just over 100 vehicles per thousand people5, far behind that of the U.S., Canada and Australia.
The internet sector is highly synergistic and leverages infrastructure, user bases, unified language and culture, policy and talent. At over 700 million units, China has the largest population of mobile internet users6 in the world. Total value of China’s third-party mobile payments7 reached US$5.5 trillion in 2016, dwarfing the US$112 billion in the United States. Major players such as Tencent and Alibaba will continue to dominate cyberspace with their extensive platform-based services for connecting people, goods and services. By 2021, the Digital Economy in China is projected to grow to above US$1.8 trillion.
Traditional manufacturers are under pressure to evolve and become smarter to survive. Manufacturers are pursuing strategies to maintain competitive advantages in their fields, primarily obtaining technological advantage by pursuing acquisitions or innovation. There are three models that companies are following:
- to specialize in particular niche markets and become global industry leaders
- to acquire synergistic targets that can help improve productivity and potentially expand their international presence
- to develop proprietary products to capture global market share.
The Missing Equity Allocation for a Canadian Investor
Many investors who are exposed to the MSCI Emerging Market Index may already have some exposure to the Chinese economy. However, that exposure does not represent the entirety of China’s public companies. MSCI included the Chinese companies listed in Hong Kong (H-share) and the US (American Depositary Receipts or ADRs) in its Emerging Market Index in November 2015, but the onshore market (A-share market) will not be included until 20188. Prior to the announced inclusion of the Chinese onshore equity market, the offshore portion represented approximately 28% of the MSCI Emerging Market Index. Investors who benchmark their investments using the MSCI Emerging Market Index would likely have had exposure to this part of the universe.
Alongside the already large exposure in Emerging Markets to China, there may be structural tailwinds that could benefit Chinese equities in the years to come. The MSCI’s decision in June 2017 to include China’s onshore equity market in its Emerging Market Index was a vote of confidence in that market8. The C$9 trillion Chinese onshore equity market will begin with the 222 largest companies at an inclusion factor of 5%. Both the inclusion factor and inclusion universe are expected to grow in time. At a factor of 100% inclusion, China’s onshore equity market would occupy 20% of the MSCI Emerging Market Index, bringing the total China exposure in the index to more than 40% (Figure 5). Ultimately, this may mean that an MSCI China-only index could emerge and that, eventually, China is viewed as a single geographic region that demands focused investment management. The added attention for China in MSCI’s indices will mean that higher proportions of Chinese investments will be used by active and passive investors alike, perhaps creating some structural support for equities in that country. A definitive timeline does not exist yet but MSCI and regulators are engaged in conversations with China for further inclusion.9
In comparison with the offshore market’s over-concentration in Information Technology, Telecommunications and Energy companies, the onshore equity market offers a more balanced universe of companies with a more accurate representation of the Chinese economy (Figure 6). An investor may gain exposure to traditional sectors, including Industrials, Materials, Consumer Staples and Discretionary and Healthcare. An allocation in the A-share market has been shown to improve the risk-return profile of an Emerging Market portfolio or a Global portfolio (Figure 5). In Canada, investors can obtain exposure to the Chinese equity markets by allocating to the Mackenzie All China Equity Fund.
Risks and Other Considerations
There are a number of risk factors associated with investing in Chinese companies. Despite its manageable debt levels, China’s deleveraging and state-reform programs are directly addressing leverage issues within the financial system. The recently established Financial Stability Committee aims to create a unified regulatory framework to enable the more efficient allocation and accessibility of capital. Contrary to market expectations, the Chinese Renminbi rate demonstrated its resilience in 2017 and appreciated 5.2% against the US dollar (Figure 7). There was also sufficient liquidity In the market throughout 2016 and 2017.
The Chinese market is one of the most dynamic equity markets in the world. The opportunities are too big to ignore but China’s market requires local expertise to navigate its waters successfully. Long-term investors are more likely to reap benefits, while short-term speculative investors may see subdued benefits. It is imperative to leverage the expertise of managers who have extensive understanding of China’s market. Over the next decade, China will produce many global businesses with products and services sold around the world. This is an opportunity for Canadians to make Chinese companies long-term holdings to enhance the risk-return profiles of their portfolios.
China Asset Management Company Limited, the sub-adviser for the Mackenzie All China Equity Fund, is one of the leading asset management firms in China. By investing in the fund, investors can gain exposure to the Chinese economy while leveraging the market insights of hundreds of investment professionals.
- Shares of Chinese companies, traded in China
- Shares of Chinese companies, traded outside of China in Hong Kong
- Standard deviation
- National Bureau of Statistics of China
- sourced from Bureau of Statistics of different countries, compiled by ChinaAMC
- China Internet Network Information Center (CNNIC)
- Financial Times: https://www.ft.com/content/e3477778-2969-11e7-bc4b-5528796fe35c
- China Asset Management Co.