Chinese equities have been the standout asset so far this year. One of the rare areas where investors have made a positive return. This may seem odd given the fact that COVID-19 originated from China. There are, however, several good reasons why Chinese equities have been one of the best-performing asset classes year to date – as I first outlined back in March on the Equities Forum blog.
It should be noted that China’s strong performance this year follows on from 2019, where it again topped the performance lists. The pace of recent gains is fast, but it is a continuation of a trend of outperformance rather than the start of a trend.
There is one aspect behind China’s outperformance that I’d like to look at in a little more detail; the market’s composition. The relationship between a country’s stock market and its economy is nuanced. There are countless empirical studies that show there is little, or no, correlation between the long-term performance of a country’s economy and its stock market. However, the shape of a country’s economy can be reflected in the composition of its stock market. This is very much the case in China.
The past twenty years has seen a huge shift in the global economy, with China a key beneficiary of globalisation, sparked by the formation of the World Trade Organisation (WTO) in 1995. China’s economic transformation began around the turn of the century with it becoming the de-facto global manufacturer. A vast (and crucially cheap) labour force saw China take on a huge role in making low value-add goods which were bought by the rest of the world. Consumers wanted low prices, China in effect offered them. In doing so, it exported deflation. It took enormous market share in the global manufacturing supply chains. With economic development came rising levels of wealth via increasing wages and property values. Over time, this inevitably eroded China’s competitive advantage and impacted its role as the world’s ‘low cost’ manufacturer. The past ten years has seen a rapid increase in gross national income, and China’s economy has pivoted towards a more consumer-led model. China is no longer a low-income economy, it is fast approaching what’s considered high-income status. It is consumption, not exports, that is the key driver of China’s economy today.
This economic evolution matters to equity investors because these changes have been mirrored in its stock market. When China became a manufacturing powerhouse the key economic sectors were energy, materials, construction, and industrials, as the economy grew incredibly rapidly. The stock market reflected this; there was scant representation of the consumer. As the economy matured, with growth moderating to more sustainable levels – driven increasingly by domestic factors – the stock market’s composition changed too. The following chart shows the changing face of the Chinese market over time – splitting the market into ‘Old’ and ‘New’ economy sectors. The New economy sectors; consumer discretionary, consumer staples, healthcare, IT, media and entertainment now account for two thirds of the market.
Equity investors do not buy countries, or economies, they buy companies. Buying Chinese equities today is a very different proposition to what it was ten years ago. It is the composition of the market today which is, arguably, the key reason behind the market’s strong run. This has occurred despite a backdrop of slowing global growth and rising protectionism.
Almost half of the MSCI China Index, by market cap, is in companies with ‘online’ business models; comprising entertainment and retailing. Naturally, these businesses have weathered the COVID-induced lockdown better than most other parts of the market. Two stocks alone, Alibaba and Tencent, account for just over 30% of the MSCI China Index. The situation in China is similar to what we see in the US where the FAANG stocks dominate the S&P 500.
Investing in China still comes with a health warning. The headlines we read can, on occasion, seem alarming – but perhaps misleadingly so at times. We always need to keep in mind that there are two very distinct Chinese stock markets – the onshore Chinese A-shares; traded on exchanges in Shanghai and Shenzhen, and the offshore market representing Chinese companies listed in Hong Kong, H-shares, and those with American Depositary Receipt (ADR) listings in the US. International investors will, predominately, access Chinese equities via funds or portfolios that largely invest in the MSCI China Index, or its constituents, which is largely comprised of H-shares and ADRs. Investors’ experiences of the onshore and offshore markets can be very different.
We have recently seen extreme levels of volatility in the Chinese A-share market, as share prices have soared over the past month. The A-share market is almost exclusively owned domestically, and is one where individual investors play an incredibly pivotal role. Individuals own c.20% of the market, by market cap, yet account for almost 80% of the market’s turnover. This statistic really catches the eye and explains why the A-share market can be so volatile. Retail investors behave with a seemingly ‘day-trader’ mindset. This short-term behaviour is also compounded by the use of margin; whereby retail investors can borrow money from their broker to invest into the market. Leverage exacerbates the market volatility.
We have recently seen fuel added to the fire of this retail-induced volatility, by state-led media campaigns extolling the virtues of the bull market. As a consequence, we have seen some incredibly large daily moves in the market as retail investors rushed to jump on the bandwagon. However, given the pace of these rises through the beginning of July we are now witnessing a change in the government’s media strategy; adopting a more cautionary tone to try to stem a potential ‘market bubble’.
Echoing the evolution we’ve seen in the composition of the Chinese stock market, we are seeing a number of market-led reforms which will serve to broaden out the investor base of the A-share market in time – particularly with regards to a more institutional, international investor cohort accessing China. Chinese equities are a huge component of the emerging markets universe today, accounting for just over 40% of MSCI Emerging Markets Index. However, China is, arguably, underrepresented in wider global indices; only accounting for 5% of the MSCI AC World Index. This will change in time.
While the market’s rise this year is eye-catching, against a backdrop of trade wars and the COVID-19 pandemic, there are good reasons for this. Going forward, what we need to keep an eye on is the valuations of those large internet companies – are their business models as bullet proof as the valuations are implying?
With regards to the Chinese A-share market, it will also be important to monitor retail investor sentiment, which has the potential to rapidly impact aggregate valuations. Just recently, we saw the largest IPO in China for a decade, SMIC, which listed on the Star Board of Shanghai. SMIC is a semiconductor company that has never earnt a return on capital above its cost of capital and, yet, still listed on an eyewatering 4x price-to-book multiple. Its shares rose over 200% on the stock’s first day of trading.
China’s markets are not necessarily in bubble territory today, but are perhaps not far away.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.