June 2017

The case for Chinese equities

Summary

We continue to see potential opportunities in what we see as an under-owned asset class. Economic data continue to show momentum in activity across a number of sectors and we are seeing progress on supply-side reforms, which has helped corporate profitability. Nonetheless, risks remain particularly the impact on future growth from the ballooning debt.

Overview

Global investors have been wary of embracing China on concerns of an increasing debt load, persistent capital outflows and potential geopolitical tensions. Yet today there are structural and cyclical forces in play that make China’s equities worth considering. While recent economic data have been somewhat mixed, we expect global reflation and a domestic cyclical upswing to help support upside in earnings. We see signs of China actively rebalancing its economy and becoming less reliant on credit growth as a positive development.

Undemanding valuations and diminishing risks over a potential trade war with the U.S. add to China’s attractions. Furthermore, trade has become a smaller growth driver than in the past, and China is strengthening ties within Asia and making its economy more consumer-driven.

The bottom line

Chinese stocks may be supported by a flexible policy that aims to stabilize growth ahead of the 19th Party Congress this fall. Many of China's challenges seem discounted in market valuations, and profitability has improved thanks to supply-side reforms. The ongoing liberalization of the financial system may gradually increase opportunities for foreign investors to participate directly in China’s markets. Still, in the near term, we continue to monitor closely the pace and magnitude of targeted tightening by the central bank as it could impact credit growth and economic activity. Longer term, China’s ever-growing pile of debt remains a challenge.

China: When investors aren’t fully rewarded

Global equity performance vs. real GDP growth, 2000-2016

When investors aren't fully rewarded

Sources: BlackRock Investment Institute, MSCI, Thomson Reuters and HaverAnalytics, March 2017. Notes: Annualized, dollar-denominated equity returns are based on generic MSCI national indexes. Annualized GDP growth percentages are based on the countries’ national accounts. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

H and A shares: An explanation

China H-shares are listed on foreign exchanges such as Hong Kong, while A-shares are listed on onshore exchanges. Domestic investors –primarily retail –buy shares in China’s onshore markets while international investors access China through offshore H-shares. Onshore shares are often driven by momentum and have been subject to dramatic speculative booms and busts in recent years. Foreign institutional investors have historically been confined mostly to investing in offshore markets.

The different investor bases –and level of sophistication –explain much of the valuation differential between the two markets. Dual-listed large mainland Chinese companies currently trade at a near 20% premium on onshore markets versus their offshore counterparts, according to Thomson Reuters data. This premium has roughly halved in the past year. It may erode further as programs allow mutual market access for investors between mainland and Hong Kong exchanges.