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Is China being overlooked in global
investment portfolios?

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Fear can be paralysing, and this may go some way to explain the reluctance of European investors when it comes to Chinese and Asian equities and bonds.

Foreign investors held just 2.3% of China’s US$8 trillion equity market and 1.6% of the fixed income space in 2017, according to Bloomberg’s analysis of data from the People’s Bank of China.

Investors worry about the ability of China’s economy to keep growing, about the lack of liquidity in the market, about the accuracy of economic data and about debt levels. More recently, fears about a potential trade war have been added to the list, as the US moves to protect its domestic industries.

These fears will never completely disappear. But China is making steady progress in rebalancing its economy away from an export-led model and towards a consumption-led one to harness the spending power of its growing middle classes. At the same time, it is addressing many of the underlying structural issues. 

All of this leads BlackRock to believe that now is the moment to reassess China’s potential. 

Financial integration

Wei Li, head of EMEA investment strategy for BlackRock ETF and Index Investments, says it is “baffling” that China does not yet have greater representation within global financial markets, despite the clear direction of travel.

Over the past 20 years, China has achieved successful economic integration and positioned itself as central to global trade. But its integration into financial markets has been much slower, mostly due to its tightly-controlled capital markets.

Now, a raft of both structural and capital reforms, aimed at accelerating financial integration, is seeing more funds flowing into China, albeit primarily from local markets.

For some time now, BlackRock has been calling out to global investors and encouraging them to pay more attention to China, and the Asian funds that it contributes to more broadly, as part of their portfolios.

“I feel like we’re at a pivotal moment,” says Belinda Boa, head of Active Investments for Asia Pacific and CIO of Emerging Markets, Fundamental Active Equity at BlackRock. “I think that lack of ownership from global clients is going to change.”

Index inclusion

One of the biggest drivers of increased flows into China, is the inclusion of 230 mainland traded stocks to the benchmark MSCI Emerging Markets index.

When Chinese shares are added to the index, the money that follows the benchmark must buy Chinese stocks to avoid deviation.

Analysts estimate that about $20 billion will initially flow into Chinese stocks. That amount could rise to $300 billion if there is full inclusion, as many market watchers expect.

Wei Li describes the decision to include the shares in the index as “a baby step but a step in the right direction.”

She believes that China will one day represent 50% of the MSCI Emerging Market Index and that it will be the biggest driver of growth in the medium term. Over time, it could even become an asset class in its own right.

Total China exposure within the MSCI EM Index

is-china-being-overlooked-chart

Source: BlackRock, MSCI, as of April 16, 2018. Notes: Index constituents subject to change. The percentage number refers to the inclusion applied to the free float-adjusted market capitalization of China A-Share constituents in the pro forma MSCI China index. Numbers may not add up to 100% due to rounding.

China already far outstrips any other country as a proportion of the index. At the end of December 2017, MSCI calculated that Chinese stocks represented 30% of its Emerging Market Index, compared to 9% for India, 7% for Brazil and 3% for Russia.

Diversification opportunities

To date, local markets have been driving the flow of funds into China. But the start of the new Stock Connect scheme – which links the Shanghai and London Stock Exchanges – will give international investors easier and more direct access to China A-shares.

These are the stocks of companies based in mainland China and traded on the Shanghai and Shenzhen exchanges rather than the H-shares which are available through the Hong Kong exchange.

Actively acquiring these stocks can be an effective diversification strategy, according to Li.

China A shares have a low correlation to developed market indices, with BlackRock’s analysis of Bloomberg figures showing a correlation of just 0.2% between the Shanghai Composite Index and the MSCI World Index. That is significantly lower than the correlation of 0.6% between developed markets (MSCI World Index) and emerging markets (MSCI EM index) more generally.

“This provides significant diversification benefits to investors looking for hedges and protections,” Li says, especially at a time when global economic policy is starting to normalise.

Measured policy changes

A lack of familiarity with Asia is another factor that might have deterred global investors so far.

But greater knowledge should help deter fears, with a presence in China providing a clearer view of how reforms are being carried out.

“I think your proximity to China definitely gives you a different perspective,” says Boa, who leads BlackRock’s team on the ground, which includes about 25 equities investment professionals, and about 20 fixed incomes ones.

Take deleveraging, for example. The market fears that any tightening might be too aggressive and result in short-term stress.

However, BlackRock’s head of China Equities, Helen Zhu, believes policymakers have been very practical and moderate in their approach to the deleveraging agenda so far, by making structural changes on one front but also ensuring that there is sufficient liquidity to avoid any stress in the financial system.

Policymakers are also addressing over-inflated property prices by increasing the supply of social housing and are actively addressing concerns over both pollution and corruption.

And Zhu believes there are more positive surprises to come on the reform side, after comments to that effect from the Chinese President Xi Jinping speaking at the World Economic Forum Annual Meeting in Davos.

Consumption and manufacturing

All of this creates opportunity when it comes to choosing Chinese equities, both within so-called Old and New China.

New China includes the burgeoning tech sector and retail firms that look to the growing spending power of the middle classes, as China repositions its economy to focus on consumption rather than manufacturing.

Meanwhile, Old China – industries such as coal, steel and commodities – can also demonstrate growth. Some of the biggest performers in 2016/17 were these older firms as they start to benefit from aggressive reforms.

As with any investment decision, it will not be a completely smooth ride and there will be bumps along the way. 

There is a Chinese proverb that says when the direction of the wind changes, some people build windmills while others build walls.

When it comes to investing in China’s stock and bond markets, the direction of the wind has definitely changed, according to Li. But not enough windmills are appearing yet.

China’s president Xi Jinping told the 19th party congress that China was at a “historic juncture” and was “entering a new era”.

It is possible that those words also apply to the opportunity that China – and Asia more broadly - offers global investors.

Learn more about Asian Equities

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