China remains the growth engine for the global economy. With the revival in full swing, Chinese economic growth is beating expectations once again, with annual GDP growth of 6.9% in June 2017. Moreover, most economic data released afterwards were not up to expectations, which raised a question of whether this sentiment is warranted or not.
However, the link between equity returns and GDP growth is notoriously weak. Valuations therefore carry increased importance. Sizing of any emerging market positions are also important, as risk and reward must be considered, especially the way the exposure may act under stress relative to other core holdings in a portfolio.
While it is tempting to compare the greater growth opportunity in terms of economic metrics, an investor is better placed framing the discussion around the investment opportunity. From a growth story perspective, an investor should focus on the fundamental developments that matter to the investment universe in question. In this regard, China and Hong Kong are two very different markets.
Profit margins are a key fundamental input, but are likely to be misleading in Hong Kong as they have become very elevated following the property boom and the consequent gains in residential development, significant because approximately 60% of the Hong Kong market is invested in real estate and financials. In mainland China, diversification means that profit margins are less influenced by the property boom.
Ultimately, an investor should attempt to understand the sustainability of earnings and dividend growth, and while there are selected opportunities to invest in both Hong Kong and A-shares, we find that mainland China is slightly more attractive once adjusted for the price you pay.
It is worth noting that the China A-shares provide a better representation of the broader Chinese economy through access to a more diversified range of industries/sectors. While Hong Kong has been the typical access point for those that wanted access to the China story, exposures have typically been concentrated in financials, internet and real estate companies.
Does MSCI adding A-shares to its index change the picture?
The reality is that the inclusion weight of China A-shares in the MSCI Emerging Markets Index is very small and is unlikely to materially impact the underlying fundamentals of the key markets Taiwan and South Korea. On the other hand, Morningstar’s own index group has so far decided against adding China A-shares to the Morningstar Emerging Markets Index, citing the lack of any revision or clarification from authorities on the issue of ownership limits. However, we recognise China’s strong commitment to reform, and the brisk pace of implementing new measures.
If done correctly, the addition of China A-shares therefore potentially allows for better diversification of the benchmark and some active managers’ relative performance drivers. Most notably, this includes better access to the growing middle-class, but it also provides access to companies with limited or non-existent foreign competition. This arguably creates a better link to the long-term growth drivers of the Chinese economy and access to companies that operate in industries that pass under the radar of government. In other words, the most frightening risk to an investor in Chinese equities is government intervention.
What are the Risks of Mainland China?
We have seen Chinese authorities move on more than one occasion to distort prices, with trading halts and short-selling bans used to stem capital flows. Moreover, there are hidden layers of government intervention from within private companies and capital allocation. The most notable has been the use of privately-owned banks to implement government policy. The reality is that one can’t be guaranteed as to whether the state-owned enterprises (SoEs) will receive preferential treatment.
There are also well-documented concerns about Chinese debt levels and so-called ‘shadow banking’, and a bad debt cycle could potentially wreak havoc. This could all impact the exchange rate of the Chinese yuan, where an investor is required to consider the sensitivity of any currency moves to their portfolio outcome. Therefore, while market regulations have been improving, mainland China exposure carries many risks that warrant a margin of safety.
More broadly, one should also be cognizant of the risks that affect emerging markets more generally. China is not immune to these risks, with untested management, weak financials, poor ESG, liquidity concerns and geopolitical/policy risks well-known points to consider.
From an investment selection perspective, there is scope for active management to add value in mainland China if fees are contained. In this regard, passive holdings may be susceptible to weakness, especially with highly leveraged state-owned enterprises to consider.
Lastly, the choice between a standalone allocation or as part of a broader emerging market allocation must be contemplated seriously. Emerging markets are a very diverse opportunity set, with Asia, Latin America and emerging Europe all offering different things. In this regard, emerging Europe may offer a better long-term opportunity based on current valuations and thus requires an investor to think outside of the China growth story.
The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation.
