21 January 2021
After suppressing Covid-19, China’s economy has avoided the hit that its regional and global rivals have taken. Looking ahead, GAM Investments’ Julian Howard says the intrinsic case for Chinese equities rests on the growth of China's economy and the relative under-representation of its capital markets in world indices.
One of the more noteworthy outcomes of 2020, in a year already full of them, was the sheer resilience of China’s economy and stock market amid the Covid-19 pandemic. Despite the virus originating there, China’s economy was barely dented in 2020 and its expansion and growing place in the world now look unstoppable. Contrast this with advanced economies struggling under the weight of high caseloads, blunt lockdown responses and slow vaccination rates. China’s stock markets also enjoyed an outsized return, with the MSCI China Index (HKD) up over 26% in 2020. While the ‘rise of China’ is not a new narrative, the possibility remains that 2020 will have been the year in which the process shifts into a higher gear. The question for investors is whether their allocation to this global superpower is both sufficient and direct enough, and how they might address it if not.
Controversy is likely to rage for years about how China was able to so quickly suppress the Covid-19 virus originating in Wuhan. But the fact remains that it was and that the economy recovered quickly. Those who doubt the official statistics can look to the operating revenues of western firms’ Chinese operations which all show a remarkable rebound of activity from the spring. Similarly, the International Monetary Fund’s (IMF) October World Economic Outlook shows expected GDP growth for China of 1.9% for 2020 versus -3.3%, -4.3%, -8.1% and -8.3% for emerging markets (EM) as a whole, the US, Latin America and the Eurozone respectively. For 2021, the IMF predicts China’s economy will grow over 6%, leaving the so-called advanced economies for dust. Since corporate revenues are generally (but not entirely) reflective of the underlying growth of their economies, this economic performance provides a unique fundamental support to Chinese equity markets in the months and years to come.
Chart 1: Firmly ahead and staying that way - China had a ‘good pandemic’:
However, there is more to Chinese equities’ attraction than just the performance of the underlying economy. It is also about how Chinese equities are under-represented in world indices relative to the size of their economy. At the end of 2020, China took up barely more than 5% of the MSCI AC World Index despite its economy being over 17% of the global total. The setting of benchmark weights is a process owned by committees within the index providers and those committees must eventually reflect the growing market cap of markets like China’s as investor interest grows. This in itself is probably one of the most compelling reasons to hold Chinese equities over time. For the world’s second largest economy to be represented by circa 5% of the leading global equity index that millions of investment institutions and retail investors follow is a glaring anomaly. By contrast, the US enjoys a near-60% weight in the MSCI AC World Index despite making up just under a quarter of the world economy. Admittedly the US tech sector is a key (and deserving) factor behind this. But China has its own innovative sector leaders across technology and finance too, so a perfectly legitimate strategy would be to simply express an ‘overweight’ to China as a process of broad-based recognition plays out over the coming years.
The question then becomes how best to access this theme. Active security selection has its attractions, not least because it offers the potential opportunity to avoid some of the pitfalls associated with investing in EMs generally and China specifically. These pitfalls include opacity around corporate governance and the ever-present threat of government intervention where corporate management has fallen out of favour. Regarding the latter, the recent failed Ant Group initial public offering (IPO), and publicly expressed regulatory concerns around Alibaba’s alleged monopoly status provide two glaring examples of how firms can be cut down to size at short notice. Tensions with overseas economies including the US and Europe also have to be contended with. The New York Stock Exchange recently decided to reverse course and de-list three Chinese telecom giants singled out by the US Treasury, causing confusion among investors. And a recently touted Chinese investment agreement with Europe reminded everyone that dealing with China is guaranteed to be fraught. In its statement on the deal - and much to the dismay of the Chinese - the European Union (EU) coolly spoke of “China as a partner, China as a competitor and China as a systemic rival.” All of these factors suggest volatility, upsets and surprises are to be expected for investors in Chinese firms operating both domestically and around the world. These unwanted surprises could be circumnavigated by an active security selector.
But if the intrinsic case for Chinese equities rests on the growth of its economy and the under-representation of its capital markets relative to the size of that economy, many investors may be perfectly well served simply by holding more Chinese equities than the MSCI AC World Index if they are aiming to beat the index and keep the texture of that overweight relatively straightforward, at least to begin with. This could boil things down to a simple index exposure of MSCI China, represented by onshore A-shares, HK-listed H-shares, US-quoted American Depositary Receipts (ADRs) among other categories. But stock concentration in that index is high, with the top 10 stocks taking up 50% of the index thanks to big names like Alibaba and Tencent. An alternative, and arguably purer exposure of the domestic Chinese story, might be to focus just on the A-shares as traded on the Shanghai and Shenzhen exchanges but accessible to international investors through the ‘Stock Connect’ facility. This would bring less concentration (for example financials are better represented) and the promise of exposure to the area of the Chinese equity universe most traded by Chinese retail investors, themselves set to grow as foreign asset managers start to set up directly in China.
Chart 2: Under-represented - China’s inclusion in the MSCI AC World lags its economic clout:
China’s ascent is nothing new but 2020 appeared to mark a turning point for the country. Its economy never took the hit that its regional and global rivals did, and the next few years look set to deliver continued strong growth. A significant opportunity potentially awaits investors who maintain a structural overweight to its equity markets in excess of the meagre allocation currently defined by the MSCI AC World Index. Volatility and stock-specific shocks will inevitably be a function of the Chinese market’s growing pains. But whether investors opt for active security selection, onshore A-shares or simply the MSCI China Index itself, the biggest driver of return over time will surely be the initial top-down decision to invest more aggressively in this market before it takes its rightful place both in the world economy and its capital markets.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.