20 May 2019
By John Husselbee, Co-Fund Manager HC Verbatim Portfolio Growth Funds
Although less than 20 years in, predictions of a ‘Chinese century’ are already coming to fruition as the country is poised to overtake the US as the world’s top economy as early as next year. While America is still some way ahead on nominal GDP, which simply measures a country’s output, several reports show China overtaking in 2020 using purchasing power parity (PPP) exchange rates.
Among the earliest advocates of renewed Chinese ascendancy was Robert Lloyd George, whose The East-West Pendulum written in the early 1990s has proved remarkably prescient as the world turns increasingly eastward.
In short, Lloyd George predicted that after two centuries of Western dominance, China would gradually regain its pre-1800 world-leading position in terms of per capita income and technological development. After a long period as global leader – from around 1500 to the 1830s – the country fell behind as emperors closed their doors just as the west was industrialising and exploring the oceans.
China’s growing place in the world continues to have major economic consequences and, from an investment perspective, is expected to force reappraisal of ‘Asian markets’ over the coming years.
At present, China tends to fall into Asia or emerging market funds and most of the allocation has been via Hong Kong-listed businesses, known as H-shares. But as access to mainland-listed equities, or A-shares, continues to improve, investors need to work out how this landscape is changing. If we have UK, Japanese and US funds, how long until China vehicles demand inclusion in a balanced portfolio?
In terms of Chinese businesses, analysis from Allianz Global Investors shows Hong Kong hosts a disproportionate amount of the country’s more mature, ‘old economy’ stocks in sectors such as real estate, banking, telecom and utilities, while the tech giants are largely represented on the New York stock exchange. A-Shares, meanwhile, represent over 70% of the consumer, healthcare and industrial sector opportunities, with the latter including many of the ‘smart manufacturing’ companies.
What that means in practice is that for investors who want to tap into the macro growth story, A-shares offer a significantly wider range of opportunities than ‘offshore China’.
While ultra-bullish about China’s economic prospects, Lloyd George was more cautious about the stock market, citing widespread state control, but this is changing as the country makes its equities more accessible to foreign investors.
In 2017, MSCI added Chinese A-shares to its Emerging Markets Index for the first time, introducing 235 mainland-listed businesses: these accounted for just 0.8% of the MSCI EM Index, out of 31% total Chinese exposure and a miniscule 0.09% of the MSCI AC World, out of close to 5% total for China.
A-share representation is small because the initial weighting of individual companies (called the inclusion factor) allocated by MSCI was just 5% of each stock’s market capitalisation, and not all A-shares were included. The group has just lifted the inclusion factor to 20%, which – alongside the addition of more mid-sized companies – will triple the Chinese weighting in the EM index to more than 3% by May 2020. Analysts believe a larger MSCI weighting could help to generate up to $125bn of inflows into Chinese A-shares this year.
Looking into the future, with more than 3000 traded stocks, full representation would account for around 15% of EM indices and increase China’s overall weighting rising to 40%-plus.
All this is expected to drive growing demand for standalone Chinese funds, as happened in the mid-1990s when ‘Pan-Asian’ portfolios were split up on the back of increasing demand for pure Japanese exposure.
Mirroring what we see with China today, the idea of Asia ex-Japan came in when the country was comfortably the region’s most dominant player and the its stock market and economy dwarfed those of neighbours. This was supported by the so-called flying geese theory, with Japan in the lead position of the V formation and pulling the rest of Asia behind it.
China was seen as very much in the rear at that stage but few would argue against the country’s position of lead goose today: it surpassed Japan as the region's largest economy in 2010 and now stands at more than twice the size. In 2017, China’s GDP was US$12.3tn, having risen more than fourfold from 2007’s pre-crisis level of US$3.6tn.
But while such figures are impressive, what does all this mean for investors? Should we expect to see Asia ex-Japan, ex-China portfolios as the norm and is China’s growing dominance making existing concepts such as ‘emerging markets’ redundant? For now, many suggest these terms persist due to factors such as simple inertia and the widespread reliance on benchmarks.
For now, we see a couple of options for investors to play the A-shares story: however you feel about the ‘emerging market’ concept, this universe is split into three regions and a specialist China fund can cover off the ‘Asia’ portion alongside Emerging Europe and Latin American portfolios.
With A-shares a limited part of the EM benchmark for now – and the index therefore not fully representing this opportunity – some investors have also been supplementing emerging market exposure with an additional weighting in mainland China.
However China continues to develop, it is clearly here to stay: the pendulum has swung and investors will increasingly have to factor the region into global portfolios.
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