Market Insight: How (and Why) to Invest into the China Equity Market Correction
- Considering China is underrepresented in most portfolios, now could be an excellent opportunity to enter this market with the onshore segment primed for a valuation-related climb back.
- P/E ratios in China onshore and offshore are now each trading at about 31% discount compared to the developed market.
- Since most Canadian investors don’t have access to the Chinese market, another option is to use funds or ETFs that invest in A-shares: Mackenzie All China Equity Fund or Mackenzie China A-Shares CSI 300 Index ETF.
Investment Director – Equities
In 2018, Chinese equity markets have been down between 15% and 25% depending on the benchmark and period examined. Over the long-term, China equity has produced massive growth – in both economic and stock market terms – with volatility to match. So with the recent market decline, investors may be starting to get interested from a valuation perspective, even if they are somewhat reluctant. In this article, we address whether this correction represents a good entry point for investors and our thoughts on how best to add China to a global equity portfolio given the opportunities available today.
Finding Value in China
China equity has declined 20% on average, since the beginning of the year with the lions share of losses being absorbed by the onshore China A-shares market. To assess value, we can compare the China equity markets’ P/Es versus their own long run median P/Es. From this perspective, at least one segment of the China equity market – the onshore segment – seems to present good value; at 13.5x it is currently trading at a 24% discount to its long run median P/E of 17.7x. By contrast, at about 13.5x the China offshore market is trading at about its long run median P/E.
Another perspective we can examine is whether China equity represents good value relative to other opportunities available to global equity investors. To examine this, we simply look at the current average P/E of the MSCI World index and compared it to the P/E ratios of the MSCI China Index stocks (offshore1) and MSCI China A stocks (onshore2) stocks. Those who watch developed markets closely might not be surprised to know that those stocks are indeed trading above their long run average P/E. Note, a paper released last year from Mackenzie hinted at the implications of such a high average P/E ratio. However, our current research shows that some segments of Chinese equity P/Es are trading at or near historic discounts to P/Es in the developed markets, as far back as our data set goes (Mar-2005).
That is the P/E ratios in China onshore and offshore have median 3% and 25% discounts to the developed market, respectively, and they are now each trading at about 31% discount. That represents about 28% and 6% reversion should it go back to its long run median.
Stocks today are running at higher valuations than they have historically – see our 2017 paper on global equity valuations – and the scale of the mispricing is large enough to provide some buffer to upside potential of this opportunity. For every 1% of overvaluation in the developed market index, 1% can be reduced from reversion potential described above.
Unlocking the Value
We now look whether there is some event or market evolution which may catalyze the reversion opportunity we have exposed. We think there is, and it may be accelerating. Earlier this year the MSCI Indices started including A-shares in its emerging markets indices, signalling their importance to the global equity complex. The initial inclusion rate3 was 5%; a few weeks ago, MSCI announced that it would consult to raise the inclusion rate to 20% in 2019. If adopted, implementation would be in May and August. This would create some additional tailwind to our valuation story (see our 2018 paper on MSCI Inclusion), so this move gives us more confidence investing in China equity generally, and A-shares valuation theme specifically. While we cannot predict what the inclusion of MSCI or other index providers will be in the future, as we discuss in our paper, a glide path to 100% inclusion in MSCI’s case is a glide path to the MSCI EM comprising 43% total China weight.
Engaging the China Market
Given this analysis, it appears China A-Shares – the onshore segment of China equity – is the better-primed pump for a valuation-related climb back. But what are the differences between onshore and offshore China equity? In short, onshore China equity stocks are less concentrated in IT and more exposed to the sectors linked to the consumer benefits of a growing middle class. In my opinion, investors selecting onshore China investing, or even an onshore/offshore mix, are selecting a more diversified basket of securities.
So, how would an investor look to capitalize on this potential? The most direct way would be through the Hong Kong – Shenzhen Stock Connect program, which is how westerners buy stocks in the China market. Most investors don’t have access to that market. Another option is to buy a fund which invests in A-shares. In this way Canadian investors don’t have a lot of options in the fund marketplace, but Mackenzie has two options for investor to select from. The first is an actively managed fund – Mackenzie All China Equity fund – which invests in onshore and offshore China equities, and would be better for investors still concerned about downside. While active investors are often able to capture far less than 100% of the down markets, they are also often not capturing 100% of the up markets due to their risk controls. For investors wanting a more direct exposure in their portfolio, a passive ETF may be a better option and Mackenzie has an ETF which tracks the CSI 300 stock index – Mackenzie China A-Shares CSI 300 Index ETF – an index comprised of China’s most liquid 300 stocks traded in Shanghai and Shenzhen.
The last question investors may ask about China investing is how much to put into a China equity investment. Earlier this year we released some guidance on this as well and depending on the risk tolerance of the client we showed the affect on a Global equity portfolio of anywhere from 5% to 25% of equity exposure in China.
While Chinese equity market can be a volatile and opaque place to invest, we believe the recent market moves present investors with a good valuation opportunity to enter this market. Onshore China equity seems to have the largest short-term opportunity, but investors wanting to invest for the long term will find fair valuations in the offshore market as well. While China would never make up the majority of an investors financial assets, we believe that China is underrepresented in most portfolios relative to the GDP impact on the world and capitalization of the companies that trade there. We believe now is an excellent opportunity to shore up any underweight to this market.