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February 2019

The case for Chinese equities

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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Summary

  • Chinese stocks stumbled in 2018 on the impact of tariffs and slowing growth. We find trade tensions are reasonably priced in to Chinese equities, however, and view the current risk/return profile as quite attractive.
  • Accommodative policy measures and sustained earnings growth in China could lift investor sentiment.
  • Global ETP flows show investors are increasingly taking a single country view on China instead of accessing it through broad EM index exposure.

Trade war: challenges & opportunities

The year 2018 was a rough one for China’s financial markets. Rattled by an aggressive campaign against high leverage and rising trade frictions with the U.S, Chinese equities plunged 18.8%1, recording one of their worst performance in years. Recent negative surprises in China’s macro data finally started to highlight more clearly the impact of tariffs on both exports and imports, adding to broader anxiety about a global growth slowdown.

The Trump administration has imposed 10-25% tariffs on a total of $250 billion of imports from China and implemented new rules to restrict China’s overseas investments in sensitive U.S. industries such as semiconductors and aircraft. Last December, the U.S and China agreed to put further tariff hikes on hold for 90 days while resuming negotiations, offering some respite from a year marked by escalating trade tensions.

While structural tensions between the U.S. and China are likely to persist over the long term, we see room for trade frictions to subside in the short run. Both sides have incentives not to escalate the conflict as the attempt to delink the world’s largest two economies is detrimental to global growth and would hurt both economies. Recent U.S. market volatility has led to wider recognition that trade tensions could hurt domestic business confidence and employment. After seeing the negative impact on sentiment, Chinese leaders have promised to take targeted measures, such as increasing U.S. imports.

Demands made by the U.S. are two-fold. First, on bilateral trade, China has already pledged to address the imbalance by purchasing more U.S. goods. Second, the U.S. asked for a more open Chinese economy with intellectual property protection. Progress made on those two fronts could lead to potential upside surprises in 2019 and boost Chinese equities.

Chart 1: Recent Chinese trade slowdown shows negative impact of tariffs

Chart 1: Recent Chinese trade slowdown shows negative impact of tariffs

Source: Bloomberg, Blackrock, as of 1/15/19.

Policy support: more to come in 2019

The trade war hit China at a particularly challenging time as the country has been combating its domestic debt problem while pushing towards a consumption-driven growth model. The fast-paced deleveraging campaign to clamp down on excessive credit expansion has drained liquidity and reduced credit in the market, causing a slowdown in growth and investments. This had a disproportionately negative impact on private companies, as the government’s financial and policy support were increasingly given to state owned enterprise (SOEs) over the past five years.

However, with leverage and overcapacity reduced, we see more stimulus measures from Chinese policy makers to stabilize the economy and support sentiment.

1. Easing monetary policy:
Chinese policymakers have rolled out a number of monetary and regulatory easing measures to help support growth. Recently, China announced 1.3 trillion yuan ($193 billion) worth of new measures including tax cuts for small businesses and reduced tariffs. The People's Bank of China cut reserve requirement ratio for most banks by 100 basis points in January, which will result in an injection of 750 billion yuan ($109.2 billion) in cash into the banking system. Although the effectiveness of monetary transmission in China has been impaired last year by a record number of corporate bond defaults and tighter financial regulations, the subdued inflation levels in China allow policy makers more room for monetary easing.

2. Improving market openness:
China has recently eased restrictions on foreign ownership of securities ventures to allow foreign companies to form wholly owned companies in China. Additional improvements in the business environment and the development of free trade zones could offer more opportunities for foreign companies to enter China and encourage domestic competition.

3. Supporting the private sector:
As the private sector accounts for 60% of China’s GDP and 80% of employment, Chinese officials have emphasized the urgency of helping private companies and introduced measures such as tax exemptions for small companies and lower social security premiums.

4. Boosting infrastructure investments:
China has vowed to further increase infrastructure spending to support economic growth, especially on inner city construction. With recent macro data such as factory orders and retail sales pointing to a slowing economy, Chinese policy makers are anxious to offset sluggish consumer demand.

Chinese market: Too big to ignore

China’s financial market is undergoing a significant development in the way foreign investors can access Chinese equities. Last year, MSCI added 236 stocks from the China A-shares market to the MSCI China Index with a 5% inclusion factor. Starting this April, the Bloomberg Barclays Global Aggregate Index will begin to include Chinese yuan-denominated government and policy bank securities, providing foreign investors access to the world’s third largest bond market. In addition, MSCI has launched a consultation on a further weight increase of China A shares last year. If implemented, it could increase China A shares’ weight in the MSCI Emerging Markets Index from .71% to 2.8% by August 2019 and 3.4% by May 2020.2 For investors, having a view on China is moving from “nice to have” to “have to have” – it’s simply too big to ignore.

Inclusion of A-shares provides investors with a more accurate picture of – and access to — the Chinese market. A-shares provide access to sectors of the economy currently underrepresented in other share classes, with larger weights in sectors such as materials, industrials, and consumer discretionary. The “new economy” of China – areas such as the tech, consumer, and healthcare segments – is mostly represented in the offshore H-shares market.

Chinese equities have cheapened significantly to a forward PE ratio of 10.6x from the 2018 high of 14.8x (Source: Thomson Reuters as of 1/15/19). However, as the economy is driven more and more by domestic consumption, the corporate earnings outlook still looks quite stable. Analysts currently expect Chinese earnings to grow 13.6% in 2019, and any improvement in sentiment will likely lift equity multiples off their depressed levels.3

Chart 2: China’s economy is becoming increasingly consumption driven

Chart 2: China’s economy is becoming increasingly consumption driven

Source: Thomson Reuters DataStream, National Bureau of Statistics and BlackRock, as of January 2019, Note: Bars show contribution to Real GDP growth by sector.

Flows

As China’s EM Index concentration grows, investors may be well served to adopt a single country focus on China and rethink EM as EM ex-China instead. Global ETP flows suggest investors are doing just that: EM equity flows have been increasingly single country focused over the past year – a notable contrast to developed market flows which have favored broad exposures.

China focused exchange traded fund products registered record inflows in 2018, with U.S. listed dedicated China exposure gathering over $6 billion. That’s in stark contrast to the $750mm inflows across all dedicated country funds across the EM ex-China universe in 2018. Despite weak performance last year, the chart below shows dedicated China ETP flows have tended to be ‘stickier,’ with steady inflows and relatively muted outflows.

Chart 3: Dedicated China ETPs inflows outpaced all other EM dedicated country fund flows in 2018

Chart 3: Dedicated China ETPs inflows outpaced all other EM dedicated country fund flows in 2018

Source: BlackRock, as of 1/14/19. Global ETP flows shown for all U.S. listed EM single country fund flows.

Conclusion

In 2019, China’s accommodative policy measures, relatively attractive valuations, and increasing market openness present investors a potential opportunity in the largest EM economy. As China’s concentration in broad EM indexes eventually grows, potentially north of 40%, investors could benefit from taking a view on China and EM ex-China separately, just as investors do with U.S. and non-U.S. developed markets. Global ETP flows proved that investors already doing that.