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BLACKROCK INVESTMENT INSTITUTE

The role of Chinese assets

May 2021 | Strategic rivalry between the U.S. and China is creating a bipolar world. We believe investors need exposure to both spheres of growth to help meet their long-term goals.

Overview

01

An “undiscovered” market

China’s economy and capital markets have rapidly grown to become the second-largest in the world, yet foreign investors own only a minuscule share of Chinese stocks and bonds.1 We believe this is a missed opportunity for helping meet investors’ long-term goals.

02

Potential diversification

Investors will need deliberate diversification across countries, sectors and companies, in our view. How to gain exposure to the Chinese sphere of growth? It’s not just about Chinese assets; it’s about investing in companies, sectors and countries that are leveraged to Chinese growth.

03

A matter of balance

Both China and the U.S. are seeking self- sufficiency in the critical industries of the future. We believe investors need to balance the investment case for gaining exposure to both within their objectives and constraints, as well as with possible investment restrictions on each side.

A stronger narrative

China has emerged from the pandemic with renewed confidence – just as it did after the global financial crisis (GFC). Growth has bounced back to trend and foreign direct investment inflows are surging, according to the data from China's National Bureau of Statistics and the Ministry of Commerce. A stable economic backdrop has made authorities more comfortable emphasizing structural reforms over short-term growth targets, in our view. This points to greater emphasis on reducing risks in the financial sector, pursuing self- sufficiency in energy and reducing dependency on imported technological know-how.

  • The narrative around China has shifted away markedly, in our view, from concerns about the health of its financial system and credit- fueled growth.
  • Its economic and market outperformance through yet another global shock has brought sharply into focus the important role Chinese assets can play in bringing resilience to strategic portfolios.
  • It has deepened our overweight stance on Chinese assets. Such a view was in place due to their diversification potential and relatively better expected returns for Chinese assets over peers.
  • As the chart shows, China and Asia ex-Japan are projected to continue increasing their global GDP share while the GDP share of North America, Europe and Japan weakens further.

The acceleration of structural trends in the aftermath of the Covid shock has helped further crystalize our views on Chinese assets. The joint monetary-fiscal revolution in developed economies has seen interest rates plummet, lengthening the lower-for-longer outlook.

Chinese bonds as portfolio ballast

The income and portfolio ballast properties of China government bonds look relatively attractive at a time when developed market government bonds ballast properties have been diminished. Global debt levels have risen sharply as Western governments have put in place a fiscal impulse many multiples of what was seen during the GFC even as the overall estimated economic loss from the Covid shock is expected to be a fraction.

China’s overall debt levels should be viewed in this context, in our view. The economy has rebounded without adding huge new debt – an important evolution that speaks to the focus on the quality of growth over the quantity,

Seeking new diversification

The chart shows how including China assets may have helped during periods of market stress

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selection a product or strategy. Indexes are unmanaged and not subject to fees. It is not possible to invest in an index. Sources: BlackRock Investment Institute, with data from Refinitiv, May 2021. Notes: The chart shows the performance of a hypothetical UK family office multi- asset portfolio through four periods of global market stress in the last 15 years. The dates for the specific scenarios considered are: 2008 market selloff (Sept .12-Nov. 3, 2008), Global financial crisis (Dec 3, 2007 –Mar 9, 2009), Fed tapering (May 21, 2013 –June 24, 2013), market selloff 2020 (Feb. 19, 2020 –March 23, 2020). Risk calculations are performed using BlackRock Solutions Aladdin risk model. Index proxies are shown on page 12 in the appendix. The chart performance analysis shown above is for informational purposes only. It should not be misinterpreted as constituting the actual performance of any particular asset class or strategy and should not be relied upon in connection with any investment decision. This data presented represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

Economic resilience is ever more important where two poles of growth may likely result in a decoupling of economies and investment opportunities.

We believe viewing Chinese investments solely as an alpha opportunity risks missing the bigger picture – investors need to ensure they have greater allocation to this key pillar of global growth.

The chart shows the performance of a hypothetical UK multi- asset portfolio with and without an allocation to Chinese government bonds and equities in past major market events.

See PDF for the breakdown by asset. In each instance, an allocation to China would have helped the portfolio better weather these episodes of market turbulence.

What we considered:

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China’s rise

China’s presence on the global stage is becoming ever more prominent. Yet its representation in benchmark indexes is far below its economic and technological importance, as shown in the first chart. Trade volumes and direct investment inflows - both at record highs – show little sign of U.S.- China trade tensions impeding the country’s rise.

The chart on the left shows China's global share of population, GDP, and world exports vs its weight in benchmark indices. The chart on the right shows each bloc's share of global GDP

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index Sources: BlackRock Investment Institute and IMF, with data from Datastream Refinitiv, June 2020. Notes: The left chart show shows China’s representation across major macro and market metrics. We use the Bloomberg Barclays Global Aggregate Index and MSCI ACWI equity index as proxies for global bonds and equities respectively. The right chart shows each region’s combined share of global GDP on a purchasing power parity basis.

A nuanced picture

The path forward for U.S.-China relations may be more predictable under U.S. President Joe Biden’s administration compared with recent years. The U.S. and China have committed to working together to tackle climate change, suggesting some re-engagement on key global issues. Yet we believe the strategic rivalry between the two powers – across multiple dimensions – is likely to persist.

Economically, China has an ambition to double GDP by 2035 – surpassing the U.S. and firmly shifting the center of gravity for global growth to Asia in coming years. See the chart above on the right. The wide-ranging plans touch many flash points in the U.S.-China relationship, with the Covid pandemic amplifying each country’s focus on economic. Secure supply chains and self-sufficiency in critical technologies and industries are a strategic priority and could drive a rewiring of global trade. Intensifying competition between the U.S. and China on key technologies such 5G and semiconductors is one example.

“Dual circulation” strategy

A key component of China’s strategy is “dual circulation.” First floated by China's leadership in May 2020, dual circulation is the concept of both increasing the resilience of the economy by a greater emphasis on supply and demand within the domestic economy while also increasing the country's economic links with the rest of the world. Recent trade deals indicate changing future trade patterns rather than declining trade - between China and its regional partners through RCEP (Regional Comprehensive Economic Partnership) and further afield with the European Union. RCEP – covering 30% of global GDP - brings China closer to South Korea, Japan and Southeast Asia. We could increasingly see countries aligning with the two poles of growth – U.S. and China led – and even being forced to choose between the two.

China’s linkages with global markets are poised to deepen – via greater index inclusion and openness to foreign investors – at the same time economic linkages are being remapped. For decades, the world was moving in a more globalized direction. Broadly, this meant that geographic exposures, such as country and region selection, were becoming less important. We believe that a considered approach to geographical diversification becomes increasingly important in a world where the almost one-way direction of travel for globalization has been interrupted. The splits across countries and regions - particularly the U.S. and China - and sectors such as technology are growing in prominence. This is true both from a return perspective - taking exposure to both engines of growth, as well as from a risk and diversification perspective - holding a greater balance of assets that are less correlated to each other.

The potential role Chinese assets can play in strategic portfolios highlights a key tenet of our broader investment views: portfolio resilience may well be driven by deliberate diversification across countries, sectors and regions rather than broad asset class correlations. Growing return dispersion between regions due to a bifurcated world with the U.S. and China at opposite poles – see the Engines of growth chart – creates more return diversification potential.

A quality revolution

A “quality” revolution

What does “quality” entail? In the context of China’s growth outlook, we believe it covers at least three areas highlighted by President Xi Jinping in January 2017 at the World Economic Forum: the environment, economic wellbeing and stability of the financial system. In other words, China wants to become a more productive economy with each unit of incremental GDP generating proportionately less pollution, inequality and financial risk (debt). This is the road to quality growth.

We believe China will prioritize reforms that emphasize these goals as policymakers view them as mission-critical in achieving a more prosperous and powerful country.

Debt and private markets

Both the West and China are undergoing a policy revolution – one of our key themes since the Covid-19 shock struck. But crucially, these revolutions are very different. Western economies are blending large fiscal and monetary stimulus, with the hope that the scale of such policy support can help achieve societal aims beyond a narrow inflation goal.

In China, we believe the revolution is a sincere effort to move away from an overriding focus on the quantity of growth towards a greater focus on the quality of growth. Western governments have put in place a fiscal impulse many multiples of what was seen during the GFC even as the overall estimated economic loss from the Covid shock is expected to be a fraction. We believe China’s overall debt levels should be viewed in this context.

China’s quality revolution and the structural changes we see unfolding in the economy has important implications for the fast-growing market for private assets. The dual circulation strategy, a push to become carbon neutral by 2060 and urbanization are long-term transformations that may not be appropriately captured by assets listed and traded on public markets today, in our view. Investors wanting to participate in such transformations may want to consider doing so via private markets but should be cognizant of the risks involved.

Tapping into private markets

Private markets may be better placed to offer targeted exposure to emerging domestic trends in China. A Bain & Company Asia-Pacific private equity survey found investors saw the biggest growth in funding businesses driven by digitization. We see real estate and private equity and credit growing rapidly in China. See charts below for details.

The chart on the left shows the share of banks and non-banking financial institutions in total corporate lending in China, the euro area and the U.S. The chart on the right shows the sectors in which institutional private market investors see the biggest growth in Asia

Sources: Blackrock Investment Institute, Bank for International Settlements, Bain & Company, May 2021. Notes: the left chart shows the share of banks and non-banking financial institutions in total corporate lending in China, the euro area as a whole and the U.S. Data is as of September 2020, the latest available from the BIS. The chart on the right shows the sectors in which institutional private market investors see the biggest growth in China according to a Bain & Co 2021 survey.

Sustainability in focus

Sustainability in focus

Sustainability will be a powerful driver of global returns in the medium term, in our view, and ever more central to all investment decisions. There are many aspects to sustainability – and the weight placed on each differs across investors. As a result, the overall assessment of China is investor specific. We consider both the current status as well as the direction of travel when it comes to assessing China’s sustainability credentials. We see improvement on several fronts – notably its environmental commitments – but recognize there is further to go, and commitments need to be realized.

Our asset return assumptions (CMAs) incorporate the impact of climate change on long-term asset returns. Popular wisdom has it that investing in China and being climate-friendly are at odds. We disagree. China’s commitment to a net- zero economy by 2060 was an important step – not just for its own economy, but for global progress toward climate goals. China’s economy stands to benefit the most among major nations from a “green” transition to a more sustainable world, in our analysis, than a scenario of no climate action.

In our CMAs we focus on the E in ESG. Why?

  1. There is wide recognition of the importance of climate change for economic and social outcomes.
  2. There is consensus on the measurement of an entity’s contribution to climate change via carbon emissions.

These factors suggest climate change will be a driver of returns at the broad market level. See our paper Climate change: Turning investment risk into opportunity of February 2021 for more.

Our overweight to Chinese assets versus benchmark indexes does not change after taking into account the impact on climate change on expected returns. The composition of Chinese equity indexes is better aligned with the transition to a low-carbon economy, in our view. For instance, China’s industrial sector has around a 39% share of China GDP. Yet industrials only make up 5% of the MSCI China index, which has a higher concentration in the ‘greener’ sectors, such as consumer discretionary (34%) and consumer services (20%).

Incorporating sustainability in the investment process requires distinguishing between current conditions and potential opportunities. The focus of China’s leaders on achieving a carbon-neutral economy will likely filter through to corporate priorities and objectives. The BlackRock Investment Stewardship team engages with Chinese companies – just as in other jurisdictions – to strengthen sustainability disclosures: see its framework for dealing with broader ESG issues in its global engagement priorities for 2021.

We recognize that disclosures have a long way to go. Yet we believe this should not detract from the fundamental case for Chinese assets in strategic portfolios. Some concerns on sustainability will likely persist. We expect social and governance issues to take on greater prominence in the wake of Covid-19. We see sustainability rising beyond the mere labels of E, S and G. That brings along complications that often relate to lack of proper data. There is some ways to go on achieving adequate disclosures – but we see this as a potential area of evolution and progress in coming years that should be closely watched.

Risk and return

The Chinese economy and markets have evolved rapidly and so views on risk and return cannot be anchored entirely on the past. Our case for “why China” is not based on better economic growth expectations.

In fact, our estimates of Chinese growth are modest relative to history – we estimate annual real GDP growth on average will be less than 4% in a decade. Yet our expected returns look at much more than regional GDP. Market-based earnings estimates, the outlook for profit margins, valuations and the path of domestic rates have a greater bearing on our expected returns than growth. Our estimate of the equity risk premium – our preferred metric to gauge valuations - stands at 7.3% for the mainland stock market compared with 4.3% for the U.S., pointing to attractive risk-reward for the former.

The chart shows our estimated five-year annualized returns and uncertainty bands as of April 2021

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise -or even estimate -of future performance. Sources: BlackRock Investment Institute, May 2021. Data are as of December 31, 2020. Notes: The chart shows expected total nominal returns from a U.S. dollar perspective.Asset return expectations are gross of fees. There are two sets of bands around our mean return expectations. The darker bands show our estimates of uncertainty in our mean return estimates. The lighter bands are based on the 25th and 75th percentile of expected return outcomes –the interquartile range. The regional equity markets are represented by the MSCI regional indexes. China A- shares are represented by the MSCI China A-share onshore index and China equities by MSCI China. The fixed income indexes in order are: the Bloomberg Barclays China Treasury+PolicyBank Total Return Index, the JP Morgan GBI EM Index, the JP Morgan EMBI Global Diversified Index, Bloomberg Barclays U.S. Government Index, Bloomberg Barclays U.S. Government Inflation-Linked Bond Index, Bloomberg Barclays U.S. Credit Index and Bloomberg Barclays Global Aggregate Treasury Index ex U.S. Indexes are unmanaged, do not account for fees and used for illustrative purposes only. They are not intended to be indicative of any fund or strategy’s performance. It is not possible to invest directly in an index.

We expect Chinese onshore listed equity returns to outpace broad EM and DM aggregate indexes, driven mainly by higher earnings growth and higher payout ratios than the past due to demands from international investors and pressure from the Chinese securities regulator.

We expect Chinese yields to rise, yet on a risk-adjusted basis see returns more attractive than comparable developed and emerging market government bonds. Our five-year annualized expected returns for Chinese government bonds are higher than for U.S. Treasuries. See the chart above. For expected returns on Chinese bonds to equal the expected return on U.S. Treasuries, we would need to see China government bond yields to rise sharply from current levels – an unlikely event, in our view.

Above benchmark allocation

We believe a neutral starting point allocation to China for most investors is significantly greater than that implied by benchmark indexes today. We are overweight Chinese assets, particularly government bonds, relative to their weight in broad global benchmark indexes. See our regional tilts in the geographical breakdown chart.

The chart on the left shows our preferred geographical asset tilts for bonds and equities

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise -or even estimate -of future performance. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, May 2021. Notes: The charts shows our regional tilts to government bonds and equities for a hypothetical, unconstrained, U.S. dollar, multi-asset portfolio on a 10-year horizon relative to their respective weights in benchmark indexes. We use the Bloomberg Barclays Global Treasury index for government bonds and MSCI AC World for equities. The hypothetical portfolio may differ from those in other jurisdictions, is intended for information purposes only and does not constitute investment advice. The allocation shown above does not represent any existing portfolio, and as such, is not an investible product. The allocation on the hypothetical portfolio is based on criteria applied with the benefit of hindsight and knowledge of factors that may have positively affected it's performance, and cannot account for risk factors that may affect an actual portfolio's performance. Actual performance may vary significantly from our hypothetical multi-asset portfolio due to transaction costs, liquidity or other market factors. Indexes are unmanaged, do not account for management fees and one cannot invest directly in an index.

Strategic opportunity

We believe investors, on average, are underinvested in Chinese assets – even below what we believe to be neutral levels suggested by current global benchmarks.

An internal survey of portfolio trends in EMEA conducted by the BlackRock Portfolio and Analytics Solutions group over the course of 2020 showed the average explicit allocation to China was just 0.3% to equities and a mere 0.05% for fixed income. The implied exposure via broader emerging markets allocation was also relatively slim – under 3% for equities and under 0.5% for bonds. Chinese equities are about 5% of the MSCI ACWI equity index and bonds comprise about 7.5% in the Bloomberg Barclays Global Aggregate Index.

Overall foreign ownership in onshore Chinese assets is low even after the recent surge in inflows as index inclusion has picked up. Offshore investors own 4.3% of the domestic A-share market and 2.9% of onshore bonds as of the end of 2020, according to data from the People’s Bank of China. We believe global investors should look to up allocation as access opens up. Our preferred allocation for a hypothetical UK institutional multi-asset strategic portfolio on a 10-year view is shown in the chart below.

This chart shows preferred asset allocation for a hypothetical UK multi-asset portfolio on a 10-year investment horizon.

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise -or even estimate -of future performance. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream and Bloomberg, May 2021. Notes: The chart shows a hypothetical strategic asset allocation, based on the metrics shown on our capital market assumptions website. Index proxies can be found on the Assumptions tab under the info icons in the Assumptions at a glance table. Fee assumptions are listed on the methodology tab. The allocation shown above does not represent any existing portfolio, and as such, is not an investible product. The construction of the hypothetical asset allocation is based on criteria applied with the benefit of hindsight and knowledge of factors that may have positively affected it's performance, and cannot account for risk factors that may affect the actual portfolio's performance. The actual performance may vary significantly due to transaction costs, liquidity or other market factors. Indexes are unmanaged, do not account for management fees and one cannot invest directly in an index. We use BlackRock proxies for selected private markets because of lack of sufficient data. These proxies represent the mix of risk factor exposures that we believe represents the economic sensitivity of the given asset class.

Jean Boivin
Head, BlackRock Investment Institute
Natalie Gill
Portfolio Strategist, BlackRock Investment Institute
Wei Li
Chief Investment Strategist, BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist, Blackrock Investment Institute
Ben Powell
Chief Investment Strategist for Asia Pacific, BlackRock Investment Institute
Yu Song
Chief China Economist, BlackRock Investment Institute