China took another step forwards on its journey to full integration with the global financial and investment community on Tuesday when index provider MSCI announced that it is going to include A shares (that is, shares traded on the Shanghai and Shenzhen exchanges) in its indices.
This means that - over time - a lot more investors will be buying China's A shares.
(What does this mean, and why does it matter? For more background on this, please see what we wrote here last week. In a nutshell… it's a big deal that China is taking another step towards joining the global investment club. But the actual short-term impact will be relatively small.)
A positive result, yes...
By some measures, A shares were included at a slightly higher level than expected. According to the Financial Times, "MSCI said it would add 222 A-share large-cap stocks that will account for 0.73 percent of its flagship index. That is higher than the 169 stocks originally proposed, after investors told the index provider they wanted to include the A-share version of companies that already had a listing in Hong Kong via which they were already included in MSCI's indices." (We wrote last week that the proposed changes to the MSCI Emerging Markets Index were for 169 A shares stocks worth 0.5 percent of the index.)
So, does this mean we're about to see a tsunami-like surge of capital pouring into A shares? No. The reality is that the index addition of China's A shares is just one of many small steps that will be taken in years to come.
And historically, markets that are added to indices sometimes experience a "buy the rumor, sell the fact" letdown after the actual announcement.
But there are lots of other reasons
This A share inclusion is in fact just one of many reasons to buy Chinese stocks.
There are other, much more powerful and compelling reasons…
1. China's economy is completely changing.
Creating enormous investment opportunities. For a generation, cheap labor was a centerpiece of China's economic growth. But China's labor is no longer cheap. And the country's economy has been undergoing a seismic structural shift, from being largely focused on manufacturing for export - think cheap "Made in China" toys, electronics and gadgets - to being more focused on services (everything from education to entertainment). This kind of change is what happens when a country's economy evolves and grows.
Yet… much of the world of finance and investing remains fixated on China as a manufacturing powerhouse. In the presentation that he made two weeks ago at our Asia Opportunities conference in Hong Kong, Brendan Ahearn (who is the chief investment officer of Krane Fund Advisors, a specialist China ETF company) pointed this out: Bloomberg collects estimates from 31 economists about China manufacturing PMI (this is a measure of the activity level of purchasing managers in the manufacturing sector).
But there are zero estimates for China non-manufacturing PMI (which gauges the health of non-manufacturing sectors of the economy).
This shows that even now economists (and investors) are still focused on the "old economy". It would be like having dozens of stock analysts looking at PetroChina and U.S. Steel and GE - and no one bothering with Alibaba and Amazon and Google.
2. China's middle class will turn the world of consumption upside down.
China's middle class is on fire. By 2022 there will be over 550 million middle-class people in China (or 1.7 times the entire population of the U.S.).
And, according to McKinsey, China's middle class is getting richer. In 2012, over half of China's urban households were considered "mass middle" class, with annual incomes of between US$9,000 and US$16,000. But that's set to change. In 2022, 54 percent will be classified as "upper middle" class, earning between US$16,000 and US$34,000.
That's a lot of people with a lot of cash in their pockets. And they all want what you have. So it's no surprise that China's consumer economy is set to soar 55 percent between 2015 and 2020.
3. China's stock market regulators are getting it.
One of the big reasons that investors have shied away from investing in China is that they don't trust that their money is safe there - or that the stock market's regulators know what they're doing.
As we wrote in the most recent issue of The Churchouse Letter,
"China's stock market regulators have a reputation for being heavy-handed in response to large swings in the domestic equity market. Following the bear market that took hold in mid-2015, regulators (and even the police) launched a series of market crackdowns. This included heightened monitoring of insider trading and market manipulation, along with limits on high-frequency trading and in late 2015, implementing "circuit breaker" rules designed to halt trading if the index declined by a certain amount within the trading day."
But that's changing.
As we wrote, "Chinese authorities are taking steps to encourage stable development of its capital markets. That means things like reducing leverage in the financial system. This is healthy for us as investors. We don't want to be subject to the kind of wild swings that have characterized previous booms and busts."
That doesn't mean that investing in China is as safe as holding gold in a vault in Singapore. But change happens slowly… and perceptions lag reality. Investing in China is already a lot safer than you think. And it's only going to continue to improve.
The other (cynical) reasons that China's A shares were included
The inclusion of China's A shares into the MSCI indices was long overdue. It's silly not to include the world's second-largest stock market in the investment world's most important stock market indices. As we've written before, Chinese authorities made a number of changes to conform to MSCI requirements, such as making A shares more accessible to foreign investors. The inclusion of the Chinese currency into the special currency of the International Monetary Fund, the Special Drawing Right, in October 2016, was another important sign that Chinese regulators were moving towards making it easier for capital to flow in and out of China.
But let's not forget that MSCI is also a business. Its main customers are the companies that use the MSCI indices for their funds and ETFs. And the real sign that MSCI was going to give the nod to China's A shares happened about two months ago, when BlackRock - the world's largest asset manager, and (very likely) an important MSCI customer - said that they supported the inclusion of A shares.
As the Financial Times wrote on April 20, "BlackRock has for the first time backed the inclusion of mainland Chinese shares in MSCI's global indices, bolstering the index provider's fourth attempt to have A-shares included in its benchmarks."
What would BlackRock have done if MSCI had gone a different route? As the same article noted,
"FTSE Russell, MSCI's biggest equity index rival, pioneered a "parallel universe" approach where it created a series of its benchmarks that included mainland shares alongside its existing China-free flagships… Bloomberg, the first of the big bond index providers to include China, adopted a similar approach earlier this year."
So… MSCI would have risked alienating BlackRock, which may have shifted to focus more on indices that already included China A shares. Although MSCI's decision made sense, it was also doing just what its customers (what I call the financial-industrial complex) wanted.
As we said last week, the easiest way to invest in China's A shares is via ETFs. Some of the biggest ones available on major exchanges are below. (But not all China ETFs are the same. Far from it. So make sure you know what you're buying.)
Disclosure: I am/we are long CERTAIN CHINA A SHARE ETFS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.