New Opportunities In Chinese Equities

by: Richard Turnill

Key points

  • The gradual inclusion of China A-shares in MSCI indexes creates new opportunities in Chinese equities, supporting our preference for EM Asia.

  • Last week's market tone was risk-on. Global stocks rallied, led by the U.S. Brazil's real plummeted and then rebounded, while the euro rose.

  • U.S.-North Korean leader talks this week may result in agreement on denuclearization principles - and a process for further negotiations.

China's equity market - the world's second largest by market capitalization - is opening up to global investors. We view the initial addition of onshore Chinese shares ("A-shares") to MSCI indexes as a key first step in opening access to the full range of Chinese equities. It gives investors exposure to what we see as some compelling domestic sectors and supports our preference for EM Asia including China.

Chinese and emerging markets stock correlation to global equities, 2006-2018

Increased access to the China A-share market may offer diversification benefits to global investors. The chart above shows how A-shares (orange line) have historically had a much lower correlation with global equities than broader emerging market (EM) stocks (blue line) and Chinese shares listed offshore in Hong Kong (H-shares - green line). This means A-shares haven't moved as closely with global equities during the ups - and downs.

One reason: Until recently, A-shares have been isolated from foreign capital by restrictions on foreign ownership and have been heavily influenced by the higher-frequency trading of local retail investors. Other factors include different sector exposures and ownership structures. We see the inclusion providing equity investors with more complete exposure to the Chinese economy as well as greater access to some of the attractive growth stories in China.

A primer on MSCI's A-share inclusion

MSCI incorporated 226 large-cap A-shares into its indexes on June 1, the first step in a process toward including 5% of eligible A-shares by September. Foreigners previously invested in China mainly via H-shares and U.S.-listed Chinese companies. They held just 2% of A-shares amid government quotas and investor concerns about corporate governance and volatility. China's weight in the MSCI EM Index will rise to roughly 31% from 30% after the initial inclusion. It would be nearly half if A-shares are eventually fully included.

A-shares' correlation with global equities may rise as foreigners increase exposure, but we expect this to take years, not months. For now, we see A-shares offering diversification benefits and fuller exposure to China's old and new economies. A-shares have higher exposure than H-shares to Chinese industrials and materials, whose earnings outlooks continue to benefit from supply-side reforms.

Further, we believe the market is underappreciating the global competitiveness of A-share listed Chinese manufacturers. The market-cap weight of the tech sector is higher in H-shares, but A-shares have a broader range of tech sector exposure and a larger weighting to other "new economy" sectors such as health care and consumer staples. Their share of "new economy" stocks is growing as China evolves to a consumption-driven growth model. Finally, A-share valuations appear fair, in line with long-term averages.

There are risks. Chinese equity volatility has been twice that of global equities since 2006, and A-shares staged a spectacular boom-bust in 2015. Market regulators have since implemented reforms, and MSCI inclusion focuses on select A-shares. Other risks include U.S.-China trade tensions, a rapidly appreciating U.S. dollar and China's corporate governance issues and financial vulnerabilities.

Yet economic activity in the world's second-largest economy is proving resilient, as we expected, and China's near-term economic outlook is solid. A-shares' greater domestic exposure can potentially help cushion equity investors against trade risks. We see China's financial leverage as a longer-term risk. Bottom line: A-shares' index inclusion supports our view that there is opportunity in EM Asia.

Week in Review

  • Risk-on sentiment sent global equities rallying, led by U.S. stocks. European equities lagged their counterparts. The VIX fell to levels last seen in January. The Nasdaq hit a new high. U.S. 10-year yields neared 3% before retreating.
  • European bonds sold off. Markets perceived European Central Bank officials' remarks as signaling a taper of net asset purchases by year end. The euro rose versus the dollar (USD). Italy's new prime minister confirmed the government aims to implement a range of populist policies. Eurozone investor confidence fell to the lowest level since October 2016.
  • The Brazilian real plummeted to a two-year low versus the USD before rallying on news of central bank intervention. The lira recovered after Turkey's central bank raised its policy rate more than expected. The rupee advanced after a surprise rate hike by India's central bank. The IMF said it reached an agreement to offer Argentina a $50 billion loan.

Week Ahead

Date: Event
June 12 Trump-Kim meeting; U.S. Consumer Price Index (CPI): OPEC Monthly Oil Market Report
June 13 FOMC meeting statement; eurozone industrial production; IEA Oil Market Report
June 14 European Central Bank meeting statement; China industrial production, retail sales, fixed asset investment
June 15 Bank of Japan meeting statement; Planned U.S. release of list of Chinese goods subject to tariffs; U.S. industrial production

A Singapore summit between U.S. President Donald Trump and North Korean leader Kim-Jong Un is likely to result in both sides agreeing to a set of principles on denuclearization and a process for further negotiations. This could include additional summits and other confidence-building steps.

Any process will be lengthy and risks being derailed by issues surrounding implementation, interpretations of the principles and verification. Our BlackRock geopolitical risk dashboard shows price reaction to North Korea news has been muted recently as market attention has shifted elsewhere. Tensions – and market attention – could increase quickly if talks fail.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps 1.7% 3.9% 14.2% 1.9%
U.S. Small Caps 1.5% 9.5% 19.7% 1.1%
Non-U.S. World 0.8% -0.7% 10.4% 3.2%
Non-U.S. Developed 1.0% -0.3% 9.0% 3.3%
Japan 2.1% 1.9% 14.2% 2.2%
Emerging 0.5% -1.2% 14.0% 2.8%
Asia ex-Japan 1.3% 2.0% 17.2% 2.6%
Bonds Week YTD 12 Months Yield
U.S. Treasuries -0.2% -1.6% -1.4% 2.9%
U.S. TIPS -0.1% -0.9% 0.4% 3.0%
U.S. Investment Grade -0.2% -3.3% -0.7% 4.0%
U.S. High Yield 0.4% 0.3% 2.8% 6.4%
U.S. Municipals 0.0% -0.4% 0.8% 2.7%
Non-U.S. Developed 0.1% -0.9% 2.9% 1.0%
Emerging Market $ Bonds -0.2% -4.6% -1.6% 6.4%
Commodities Week YTD 12 Months Level
Brent Crude Oil -0.4% 14.3% 59.8% $76.46
Gold 0.4% -0.4% 1.6% $1,298
Copper 6.0% 0.9% 27.6% $7,312
Currencies Week YTD 12 Months Level
Euro/USD 0.9% -2.0% 4.9% 1.18
USD/Yen 0.0% -2.8% -0.4% 109.55
Pound/USD 0.4% -0.8% 3.5% 1.34

Source: Bloomberg. As of June 8, 2018
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Asset Class View Comments
Equities U.S. icon-up Extraordinarily strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like the momentum and value style factors, as well as financials and technology.
Europe We see a sustained global expansion supporting cyclical sectors. The moderation in domestic growth and rise in political risks pose headwinds for earnings, especially for banks.
Japan icon-up Positives are improving global growth, more shareholder-friendly corporate behavior and solid earnings. We see Bank of Japan policy buying as supportive. Any yen appreciation would be a risk.
EM icon-up Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Above-trend expansion in the developed world is another positive. Risks include a further sharp rise in the U.S. dollar, trade tensions and elections. We see the greatest opportunities in EM Asia.
Asia ex Japan icon-up The economic backdrop is encouraging. China's growth and corporate earnings are solid. We like selected Southeast Asian markets but recognize a faster-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income U.S. government bonds icon-down We see rates rising moderately amid economic expansion and Fed normalization. Shorter maturities offer a more compelling risk/reward tradeoff. They and inflation-linked securities can be buffers against rising rates and inflation. We like 15-year mortgages relative to their 30-year counterparts and to short-term corporates.
U.S. municipals Solid retail investor demand and muted supply are supportive of munis, but rising rates weigh on absolute performance. A more defensive stance is warranted near term, we believe, though any material weakness due to supply may represent a buying opportunity. We favor a barbell approach focused on two- and 20-year maturities.
U.S. credit Sustained growth supports credit, but high valuations limit upside. We prefer up-in-quality exposures as ballast to equity risk. Higher-quality floating rate instruments and shorter maturities are well positioned for rising rates, in our view.
European sovereigns icon-down The ECB's negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. We are cautious on peripherals given tight valuations, political risks in Italy and the prospect of the ECB reducing its asset purchases.
European credit icon-down Recent spread widening driven by increased issuance has created some value, while ongoing ECB purchases should support the asset class. Negative rates have crimped absolute yields - but rising rate differentials make currency-hedged positions increasingly attractive for U.S.-dollar investors. Subordinated financial debt looks less compelling versus equities after a strong 2017.
EM debt Recent price moves have improved the valuations of hard-currency debt, increasing the relative attractiveness both to local-currency bonds and to developed market corporates. Further support for valuations comes from slowing supply and strong EM fundamentals. Trade fears or geopolitical risks prompting a rapid tightening of global financial conditions represent downside risks.
Asia fixed income Regional growth and inflation dynamics are supportive of credit. China's rising representation in the region's bond universe reflects its growing credit market. Higher-quality growth and a focus on financial sector reform are long-term positives, but any China growth slowdown would be a near-term challenge.
Other Commodities and currencies * Declining global crude inventories underpin oil prices, with geopolitical tensions providing further support. We are neutral on the U.S. dollar. Factors driving its recent strengthening are likely temporary, but higher global uncertainty and a widening U.S. yield differential with other economies may provide support.

* Given the breadth of this category, we do not offer a consolidated view.

This post originally appeared on the BlackRock Blog.