Article: Onshore China equities – playing the long game
- Recent economic data releases seem to be pointing to a continued slowdown in the world’s second largest economy despite the slew of monetary and fiscal support measures from the government. But we believe the softer data is in line with the overall global trend, which China is not immune to
- In addition to the promise of policy support, structural changes and market reforms undertaken by the government to transform the financial landscape have also played their part in attracting inflows
- MSCI’s milestone decision to include onshore Chinese equities in its key indices in 2018 and its subsequent call to increase the weight of China A-shares in its benchmarks has provided a major shot in the arm for China in its efforts to woo foreign investments
- We believe the increased foreign ownership of onshore equities could eventually improve the A-share market infrastructure and persuade listed companies to align their disclosure, transparency and governance standards to global peers
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A quick glance at recent newspaper headlines might suggest a discontent between the doom and gloom outlook and the performance of onshore Chinese stocks so far this year. Despite the ongoing trade conflict with the US and underwhelming economic data releases, China’s domestic equity markets have delivered strong returns (CSI 300 is up 28 per cent as of 10th October; Shanghai Composite Index has risen 18 per cent), outdoing most regional peers and many global stock markets, even after factoring in the stumbles in recent weeks.
So what’s been driving the markets? The nearly 20 per cent correction in the previous calendar year, driven by indiscriminate selling and valuation de-rating despite a double digit growth in corporate earnings, set a conducive backdrop for the pick-up. But some of the credit goes to the all too familiar ‘party put’ - which is a reference to investors’ conviction that the Chinese government will continue to roll out support measures to bolster economic growth if necessary. This optimism is not entirely misplaced - the government will cut taxes and fees totaling around USD298 billion this year and this includes a 3 per cent cut in manufacturing VAT and the 3-4 per cent cut in corporate social security contribution, which is seen boosting corporate balance sheets and consumption. To support infrastructure investment, the government has rolled out several measures, including significantly increasing the issuance quota for local government bonds.
Recent economic data releases seem to be pointing to a continued slowdown in the world’s second largest economy despite the slew of monetary and fiscal support measures from the government. But we believe the softer data is in line with the overall global trend, which China is not immune to. Targeted and calibrated stimulus measures have succeeded in propping up growth to some extent as indicated by the still largely stable albeit soft growth indicators. Equally, it is encouraging to note that the government has not veered from this path despite mounting pressure to switch to a more aggressive easing mode.
Similar to GDP growth projections, earnings estimates for Chinese companies have also been trimmed in recent quarters amidst worries about more headwinds – lack of resolution on trade frictions, growth slowdown, and currency depreciation- in the remainder of the year. But on the other hand, undemanding valuations add to the appeal of onshore and offshore Chinese stocks. Price-earnings ratio for MSCI China was trading at 11.9x, a tad below its 10-year average of 12.4x, while CSI 300 of the country’s largest companies was trading at 12.6x, about 10 per cent below its 10-year average of 14.1x. On a price-to-book basis, MSCI China and CSI 300 were trading at 1.5x and 1.8x, against the 10-year average of 1.7x and 2.0x, respectively.
In addition to the promise of policy support, structural changes and market reforms undertaken by the government to transform the financial landscape have also played their part in attracting inflows. On the equity market front, the Shanghai Stock Exchange Science and Technology Innovation Board, styled to be the Nasdaq of China, was formally opened for business in July with a stellar debut - raising USD5.4 billion with its first batch of listings. Backed by strong political endorsement, the new board – also referred to as the STAR market – will help pre-profit companies raise capital more swiftly than traditional funding routes and is thus seen as a test bed for spurring innovation and as a new source of growth in the wake of escalating trade tensions and the technology race. China Securities Regulatory Commission (CSRC) also relaxed the regulations on asset restructuring and backdoor listing in June and loosened margin financing rules in August.
Elsewhere, Chinese authorities have recently lifted some restrictions on foreign investments in the financial sector, slashing the limits on foreign ownership of securities, insurance and fund management firms in 2020, a year earlier than originally planned. China will also expand the role of foreign credit rating agencies and brokerages in the bond market and overseas brokerages will also be allowed to serve as lead underwriters for bond offerings in the interbank market.
Most recently, in September, the State Administration of Foreign Exchange (SAFE) said it had decided to scrap quota restrictions on two major inbound investment programmes–the QFII and RQFII, in a bid to make it more convenient for overseas investors to participate in China’s domestic financial markets.
While China has made big strides in opening up its equity markets, it is still a long way away from allowing overseas investors to freely trade A-shares or granting them access to domestic IPOs and ETF products. In the near future, Chinese regulators may need to revisit the foreign ownership limits of Shenzhen or Shanghai-listed companies, which is 30 per cent under current rules. In fact, authorities raised the cap from 20 per cent to 30 per cent in 2013, but the issue of foreign holding threshold was in the spotlight again in March 2019 when MSCI removed a Shenzhen-listed company from its China indices and cut the weighting of a large home-appliance maker as their foreign holdings got close to breaching the set limit.
5, 10, 15, 20 and counting
Last but certainly not the least, MSCI’s milestone decision to include onshore Chinese equities in its key indices in 2018 and its subsequent call to increase the weight of China A-shares in its benchmarks has provided a major shot in the arm for China in its efforts to woo foreign investments.
In May MSCI officially increased the index inclusion factor of all China A large-cap shares from 5 per cent to 10 per cent and increased the opportunity set by adding ChiNext large-cap shares with a 10 per cent inclusion factor. A few months down the line, the inclusion factor of more than 200 China A shares increased to 15 per cent in August and A-share’s weighting in MSCI Emerging Market Index was bumped up to more than 2.1 per cent. In the first nine months of 2019, foreign inflows into China A shares surged to USD26.9 billion, despite a pull-back in recent weeks. The increased representation (inclusion factor of 20 per cent in November 2019) could potentially bring in upwards of USD30 billion from active and passive global investors tracking the MSCI benchmarks.
MSCI has not indicated a firm timeline for full inclusion of China A-shares, which was around six-seven years for countries such as South Korea and Taiwan that underwent the process before China. Incremental reforms - including alignment of settlement cycles, access to hedging tools and derivatives – aimed at bringing the onshore markets closer to international standards could go a long way towards potentially shortening that timeline.
While the weighting increase is still being viewed as being largely symbolic, it has and will continue to prompt foreign investors to increase their exposure to the world’s second largest equity market. We believe the increased foreign ownership of onshore equities could eventually improve the A-share market infrastructure and persuade listed companies to align their disclosure, transparency and governance standards to global peers.
Source: Bloomberg, HSBC Global Asset Management as of 10 October 2019
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