Update on China

March 2017

Key points

  • Chinese equities currently appear to be an undervalued and under-owned part of the market, as considerable pessimism has been discounted into valuations.
  • 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, a deterioration in trade relations with the United States remains a risk and with a medium-term view, so does 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 a potential trade war with the U.S. Yet today there are structural and cyclical forces in play that make China’s equities worth considering.

We expect global reflation and a domestic cyclical upswing to help Chinese equities. Economic data continues to show momentum in activity across a number of sectors including consumption, manufacturing and even exports. Progress on domestic structural reforms and undemanding valuations add to China’s attractions.

The biggest near-term risk to China’s stocks is a breakdown in trade triggered by U.S. protectionism. Yet trade is 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 an accommodative and flexible policy that aims to stabilize growth ahead of the 19th Party Congress this fall. Many of China's challenges are discounted in market valuations (see chart below), 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, the near-term upside may be capped by trade tensions and the pace of structural reforms. There is also China’s ever-growing debt pile to monitor.

China: When investors aren’t fully rewarded
Global equity performance vs. real GDP growth, 2011-2016

When investors aren't fully rewarded

Source: BlackRock Investment Institute, MSCI, Thomson Reuters and HaverAnalytics, March 2017. Notes: Annualized, dollar-denominated equity returns are based on generic MSCI national indexes; with China A represented by MSCI China A index, and China H represented by MSCI China H index. 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.