Our Company and Sites
August 2018

The case for Chinese equities: A shares inclusion update

Christopher Dhanraj
Director
Head of ETF Investment Strategy

Summary

  • We are constructive on Chinese equities despite tensions over trade. We see protectionist threats as largely negotiating tactics, while Chinese reforms, a stable growth environment and a solid earnings outlook support equities.
  • MSCI will implement the second tranche of China A-shares inclusion, raising the inclusion factor to 5% from the 2.5% inclusion announced in May. All changes will be implemented as of August 31, 2018 and go into effect September 3, 2018.
  • Global ETP flows show investors are increasingly taking a single country view on China instead of accessing it through broad EM index exposure.

Still room to run

Last year, Chinese equities were among the world’s best performing assets. The MSCI China Index was up 54% in 2017, outpacing broader emerging markets, which were up 37%, and more than double the 22% return of the S&P 500 Index.1 Chinese equities have struggled year-to-date, with the MSCI China Index down -5.8%. However, we are constructive on Chinese equities amid a stable growth environment, ambitious reform agenda, and solid earnings outlook.2

To be sure, trade tensions represent a risk to Chinese markets yet markets have already priced in most of these risks, in our view. Our base case sees a full-blown trade war being averted but we anticipate an extended period of tensions ahead. Moreover, China’s trade openness peaked over a decade ago as domestic growth drivers took on added importance, suggesting the economy may be relatively insulated from the effects of higher tariffs.3

We continue to see a strong reform agenda following the 19th National Party Congress supporting China’s pivot away from the “old economy” of credit-intensive, heavy industry and towards the “new economy” driven by technology, consumer spending, and healthcare. The shift towards faster-growing, less credit-intensive sectors has the dual benefit of supporting headline GDP growth while also improving the “quality” of economic growth. President Xi Jinping’s remarks on April 10th at the Boao Forum highlighted several reform efforts aimed at further opening China’s markets and which could help alleviate strained Sino-American relations. In particular, President Xi outlined plans to further open China through:

  • Widening market access by raising foreign equity caps in the financial sector, easing restrictions on foreign financial institutions and reducing limits on foreign investment in manufacturing industries, including autos.
  • Improving the investment environment by aligning domestic policies with international economic and trading norms.
  • Expanding imports by lowering import tariffs on vehicles and holding the first China International Import Expo as a major policy initiative.
  • Strengthening intellectual property rights (IPR) by re-instituting the State Intellectual Property Office to enforce IPR and raise the cost of violating IPR to increase deterrence.

China: Too big to ignore

The positive outlook for China occurs against a backdrop of a significant development in the way investors can access Chinese equities. This June, MSCI added 226 stocks from the China A-shares market to the MSCI China Index with a 2.5% inclusion factor. The second tranche goes into effect September 3 as the inclusion factor to rises 5.0% and increases the number of stocks to 236. The MSCI EM Index currently has an approximate 30% weight to China by way of offshore-listed Chinese companies, the majority of them being those listed in Hong Kong (“H-shares”).4

Historically, foreign investors have had unrestricted access to only about half of China’s equities market (largely through H-shares). The remaining half is comprised of A-shares, the “onshore” stocks, which were only available to foreign institutions under strict quotas set by the Chinese government.

After the upcoming MSCI rebalance, the weight of A-shares in MSCI China will increase from 1.1% currently to 2.3%. China A-shares representation in the MSCI EM Index will move from ~41bps to 75 bps. What lies beyond a 5% inclusion factor is widely unknown, but two future steps could include 1) the consideration of mid-cap A-shares for index addition, or 2) a higher inclusion factor for the existing basket. In order for mid-cap A-shares to be considered for index addition, Chinese authorities would need to continue to align with international accessibility standards.

Eventually, A-shares could account for 9% of the broad EM index after 50% of the A-shares are included, and then 17% after full inclusion. A complete, 100% inclusion of A-shares could then raise China’s MSCI EM index weight to more than 40%. For investors, having a view on China is moving from “nice to have” to “have to have” – it’s simply too big to ignore.

Exhibit 1: The road to full inclusion into
the MSCI EM Index

Exhibit 1: The road to full inclusion into the MSCI EM Index

Source: MSCI, BlackRock, as of August 2018. The A-Shares weighting for the 5% inclusion factor has been rounded up from 0.75% to 0.8%.

Implications for investors

The 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, consumer discretionary and healthcare. The “new economy” in China – areas such as the tech, consumer, and healthcare segments – is mostly represented in the offshore H-shares market. The fact that the onshore A-shares market is the second largest equity market globally suggests that these secular growth themes are currently underrepresented in foreign investors’ portfolios.

Fortunately, deciding between A-shares and H-shares isn’t mutually exclusive. The complementary nature of A-shares exposure can also be seen through its low correlation with global equity markets. Investors should consider holding exposure to both markets instead of picking one over the other. Given the lingering operational complexities facing foreign investors, and the breadth of A-share names, investors may want to consider investing via an ETF structure, which removes operational burdens as well as providing cost effective, liquid and broad-based exposure.

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.

ETP flows into China focused products have remained resilient year-to-date. U.S. listed ETPs with dedicated China exposure have gathered over $2.2bn in inflows year-to-date. That’s in stark contrast to the $750mm in aggregate outflows across dedicated country funds across the EM ex-China universe. The chart below also shows dedicated China ETP flows tend to be ‘stickier,’ with steady inflows and relatively muted outflows. Dedicated country ETP flows across the EM ex-China universe show much greater reversal periods, including most recently in the third quarter.

Dedicated China ETPs inflows continue to outpace all other EM dedicated country fund flows

Dedicated China ETPs inflows continue to outpace all other EM dedicated country fund flows

Source: BlackRock, as of August 2018. Global ETP flows shown for all U.S. listed EM single country fund flows.

Conclusion

The opening of China’s A-share market and accompanying index inclusion is a landmark event for the global investor community. For long-term investors, the A-shares vs. H-shares decision is a false dilemma given complementary exposure. The real question is how much China does one need in their portfolio. As China’s concentration in broad EM indexes eventually grows north of 40%, investors should start 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 suggest investors are beginning to do just that.