Addressing the multi-trillion dragon in the room

BlackRock experts discuss how investors can tap into opportunities across China’s US$23 trillion onshore equity and bond markets.


In 2020, China’s onshore equity and bond markets grew to over US$23 trillion in assets, but exposure to China remains only a small fraction of most investor’s portfolios.

As we look ahead into the rest of 2021 and beyond, China has been top of mind for many of our clients. It’s huge, it’s growing, it’s ripe with risks and opportunities, but how does it fit into portfolios?

To help us distill the rapidly changing dynamics of investing in China, Rui Zhao, Portfolio Manager for Systematic Active Equity’s China strategies, and Philip Hodges, CIO of Factor-Based Strategies, give us a run-down of how to tap into the best opportunities in the Chinese markets and how systematic investing creates differentiated insights to seize those investment opportunities.

What do you think makes China a great investment opportunity now?

Philip Hodges: The opportunities that come from investing in onshore China can be distilled into several components. It’s the second-largest economy in the world with steep growth trajectory. The country is also shifting from exports to domestic consumption, with a big middle class to fuel that consumption. Additionally, China has been making heavy investments in technology, seeing a revolution in productivity, liberating financial markets, and opening up to foreign investors.

The opportunity in China is big, and when most people think about onshore investments, they think A Shares.

China’s A-share market consists of over 4,100 companies, and has a combined market capitalization of over US$16 trillion, making it one of the largest equity markets in the world.1 Similarly, China’s onshore bond market is roughly US$14 trillion, making it the second-largest bond market in the world.2 Despite the size of these markets, it is currently under-owned. Foreign investors hold just 3.5% of the broad market in China.3

China has shown great support for economic globalization and is already making strides to open its markets to the rest of the world. China’s economic circumstances present a potentially compelling opportunity, but current investment processes must evolve in order for investors to tap into this market.

How did you choose to respond to the 2020 investment landscape?

Also, as an investor in the Chinese markets, how will you continue to address the potential uncertainty from this drawn-out pandemic in the year ahead?

Rui Zhao: China’s digital economy has been growing rapidly over the past few years and was especially accelerated during the pandemic, which has made more data available in just the past year alone.

When China went into lockdown in January 2020 due to COVID-19, information about what companies were doing was very unknown. However, despite the uncertainty associated with COVID-19, investment decisions could benefit from many years of data accumulation. Relying on alternative data helps answer basic investor questions such as, “Which companies or industries will benefit the most from the pandemic?” and “Which companies are having their workers return to work, and when will those companies start producing again?”

Systematic research methods were key to understanding China’s investment landscape because it allowed us to deeply understand the evolution of company fundamentals during an unprecedented time.

Onboarding more types of data and developing better machine learning models for analysis have always been our research focus. This has also allowed us to make more informed decisions about a company’s future growth, the quality of management, as well as a company’s ESG profile.

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Systematic research methods were key to understanding the China investment landscape because it allowed us to deeply understand the evolution of company fundamentals during an unprecedented time.

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Rui Zhao Portfolio Manager for Systematic Active Equity’s China strategies

Can you comment on overall volumes and changes in market participants?

Rui Zhao: We have seen an increase in market turnover throughout the past year. This can be attributed to both domestic retail and institutional investors, as well as global investors. As of today, the Stock Connect Northbound flow which refers to Chinese mainland-listed stocks traded on the Hong Kong Stock exchange – has reached 2.1 trillion RMB, which is more than US$300 billion.

After a decade of investor education, domestic funds are finally becoming attractive among retail investors, and we’ve also seen the total number of ETFs holdings double over the past two years. This can be a sign that more retail investors are starting to increase their trust in professionals to manage their assets, rather than making those investment decisions themselves.

In 2020, growth seemed to have a tight linear relationship with active return. How do you think this played out in China and how did China Opportunities respond?

Rui Zhao: Over the past year, we have seen the market become more concentrated. For example, when we look at exposures, we see it centered around high growth and high volatility stocks. These factor exposures are approaching a historically high level, which happened twice in the past; once in 2008 and again in 2015. We’re not saying that the market is crashing any time soon, but it’s important to note that the level of concentration has been quite extreme. In this environment, we believe that our diversified risk control strategy will really help our clients diversify away from some of the idiosyncratic risk.

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Briefly, what does correlation look like among China macro factors?

Additionally, what does that do to a portfolio?

Philip Hodges: In terms of diversification, we saw very low negative correlations in many places across most Chinese assets. We’re used to seeing lower negative correlations in the developed market between equities and bonds, but we don’t always see that in emerging markets. We definitely see that in China. Chinese government bonds are a flight to quality assets that perform well to hedge equity risk. In credit, the situation is even rosier. Chinese corporates have a low to negative correlation both with government bonds and equities.

And this is true even if you strip out the interest rate component and just look at credit spreads. In developed markets, we’re used to pretty high correlations between credit spreads and equity markets. That level of diversification still exists in the Chinese market. Given these low correlations, it’s perhaps not surprising that a diversified multi-asset China portfolio is a good way to steadily accrue risk premia and benefit from Chinese growth.

Stock – bond correlations are low/negative similar to developed markets

Stock-bond correlations

Source: BlackRock, Bloomberg, Thomson Reuters, Wind Economic Database.

Time period: 12/31/2004 – 02/20/2020. Equity depicted as MSCI China A Index; Bond depicted as 10Y China Developmental Bank (CBD) Bond Index; IRS depicted as 5Y China interest rate swap; Credit depicted as CBOND AAA 3-5Y Credit Index; Commodity depicted as customized China oriented commodities.

Stock – credit spread correlations are much lower than in developed markets

Stock-credit spread

Source: BlackRock, Bloomberg, Thomson Reuters, Wind Economic Database.

Time period: 12/31/2004 – 02/20/2020. Equity depicted as MSCI China A Index; Bond depicted as 10Y China Developmental Bank (CBD) Bond Index; IRS depicted as 5Y China interest rate swap; Credit depicted as CBOND AAA 3-5Y Credit Index; Commodity depicted as customized China oriented commodities.

Beyond the world of equities, how does adding other asset classes into the investment mix change risk profiles and overall return potential?

Philip Hodges: There are other asset classes that diversify risk premia not just to Chinese equities, but to other traditional exposures that you may have in your portfolio. China’s bond market, for example, has more than 90% of it held domestically.4 Those interest rate exposures tend to offer much higher premia than in developed market equivalents. In the corporate bond space, risk-adjusted yield and income tend to be higher than developed market equivalents as well. If you look at the world global bonds that are yielding more than 2.5%, over 50% of those are onshore Chinese bonds.5 Additionally, we did some work looking at commodity investments and constructible indices, showing that if you tilt towards commodities that are most heavily consumed by China, they tend to offer a higher premium, outperforming in-line with Chinese growth.

Chinese equities have experienced quite a lot of volatility, but diversified portfolios tend to move more in line and more consistently with Chinese growth. If we drill into some of the biggest peaks and draw-downs in the equity markets, in 2008, MSCI China A was down 64%. Over the same period, a levered multi-asset portfolio with 100% allocation to rates (5Y China Interest Rate swap), 50% allocation to credit (China Bond 3-5Y IG Credit total return index) and 25% allocation to equity (MSCI China A) would have been up around 1% in 2008.6

So, we see plenty of opportunities for a multi-asset approach in China as diversified risk premia in different asset classes in a balanced portfolio tend to offer pretty good diversifying returns against traditional global investment.

Higher debt yields

Higher debt yields

Source: BlackRock, Bloomberg, Thomson Reuters, Wind Economic Database.

Shorter-duration bonds outperformed

Shorter-duration bonds performance

Source: BlackRock, Bloomberg, Thomson Reuters, Wind Economic Database 2020. 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 selecting a product or strategy.

What opportunities in China are you most excited about now?

Nicholas Chui: I'm most excited about three opportunities in China: dual circulation, consumption, as well as sustainability.

Now, with regards to dual circulation, the role of China in terms of its supply chain has changed dramatically. China used to just be the factory for the world, but now it's also going to be a factory for itself. In the past, people would typically approach China to produce some of the low and mid values type of goods, but this has changed because of innovation. And innovation is the bedrock for China to be able to supply higher value of goods and services to itself, as well as the rest of the world. For instance, in renewable energy where it supplies most of the solar panels required in the world. In electric vehicles as well, where a lot of the supply chain sits in China. So do circulation is definitely here to stay.

Consumption is the other area where I'm very excited about, because 10 years ago, there was a deliberate pivot away from heavy investment in infrastructure towards consumption. With the billions of people that they have today. This is a very important basis for why consumption is very important in China. This is because the rise of the middle class has given way to a new area of demand, a new total addressable market, because the rise of the middle class has as a result led to a lot of sustainable spending that we're going to see persist over the next many, many years.

The third area I'm really excited about is sustainability. China has set very ambitious net zero targets. And these targets are not just at the central government level, but also at the provincial government level, as well as the individual company level. One can actually foresee that because there is an intent to drive this from a top down measure, it will be effective, it will be done, and it will persist. And that's why we're seeing in terms of sustainability efforts, it's not just about companies meeting net zero targets or climate change targets, but it's also acting as a key supply chain provider for the world's needs to get to net zero.

These three are opportunities that I think that persist at this point in time, that have very strong support from a demand perspective, as well as the government's support perspective. And I think these are three opportunities that we are well positioned for, and these are three opportunities that I think clients will really benefit in the years to come.

How do you approach research on Chinese companies?

Kevin Jia: I think China equity market is very deep with a lot of bottom up opportunities, which also means more on the ground due diligence and corporate access are required. Within corporate access is definitely not a back-office function but create significant value before and during the investment. One case in point, was with a catering company in China, prior to this company's public listing, we already built a connection with management and conducted on site due diligence, thanks to the help of our corporate access team and capital market team, who gave us a head start, among other funds.

We also found alternative data helpful in building conviction in earnings cases as well as identifying fraud. We leverage our data and build a store number of records from web scraping from public data. So with one catering company, we identify meaningful store acceleration beyond the street forecast, generating meaningful earnings revision versus the consensus.

With the other casual beverage company, we use similar methodology, but found store opening to be having a very big gap versus fiscal reporting, then coupled with the financial study, we identify this company as a fraud. These might be relevant cases where corporate access and data advantage helps our team to form differentiated research on both long and short stock. 

What sectors are most dominant in China?

Nicholas Chui: Consumption, technology and finance are three very important and big sectors in China, and the developments there differ from the rest of the emerging markets.

In consumption, we have a very large population, but at the same time, the things, the products and services that the Chinese consumers are consuming, and demanding today are quite different from the rest of the world. In fact, quite leading edge, and they're creating a market for the rest of the world.

In terms of technology, China has been pouring a lot of attention and capital into innovation, and this is the bedrock for what we're seeing today because a lot of innovative platforms in the world today actually stem from China. There's also been a very big effort to attract back a lot of talent back into China, and that's definitely been helping the innovation efforts there.

And the third is finance. In the financial sector on the surface, it looks like it's about loans and deposits, but it actually no longer is because the financial sector itself in China has been reforming. The financial sector in China has embraced fintech, which is why a lot of banks and financial institutions have different types of platforms that allow aggregation and attraction of users at the online level. So the provision of loans and services is just the bare minimum.

But what you can do by cross-selling your financial services extends a lot more than that. And these are trends that we're seeing happen in China, a lot faster, a lot deeper and with a quicker level of intensity, a lot more than the rest of the emerging markets.

RO code: MKTGH0621U/M-1681234

Themes and sectors driving China's growth

Portfolio manager and research analysts for our Global Emerging Markets Equities team, Nicholas Chui and Kevin Jia, share their perspectives on China's investment landscape, including themes driving growth and the importance of on the ground company due diligence. Watch their insights.

Rui Zhao, PhD, CFA
Portfolio Manager for Systematic Active Equity (SAE)
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Philip Hodges, PhD
CIO of Factor-Based Strategies
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Nicholas Chui
Portfolio manager, Global Emerging Market Equities team
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Kevin Jia
Portfolio manager, Global Emerging Market Equities team
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