Feature – China
China was the first country to catch Covid-19 and is on track to be the one of the first to get the pandemic under control. This is reflected in its economic outlook. China’s economy grew 6.5% in the fourth quarter of 2020 and is expected to expand by a further 8.2% this year, the IMF believes. The improved economic outlook is being priced into domestic equities. Following March’s Covid-19 sell-off, shares listed in China recovered to close at a 13-year peak in January. While shares in Chinese companies trading in Hong Kong, known as H shares, are being overshadowed by political events in the province, most institutional investors, based on the surge in the CSI 300 index, are favouring shares trading on stock exchanges in Shanghai and Shenzhen, popularly known as A shares. During the past year alone, the MSCI China A shares index gained 43%, more than double the level of the MSCI Emerging Market index. But A shares are not for the faint hearted. The asset class, which has only become widely accessible to international investors four years ago, is notoriously volatile with peaks in 2008 and 2015 being swiftly followed by sharp declines. This raises the question: are investors who are entering the market now buying shares at their peak or will the growth spurt be less volatile this time?
No longer niche
Around a decade ago, Chinese equities would have been con- sidered a niche strategy by institutional investors in the UK. Although shares in listed Chinese companies have been trad- ing since the 1860s, stock markets only re-opened in 1990 after a near 40-year break instigated when the Communist Party took power. The market is also worth a fraction of US equities with a market cap of up to $4.7trn (£3.4trn). Three factors have helped to make A shares more accessible. Over the past 10 years, the authorities in China gradually expanded the status of the Renminbi Qualified Foreign Institu- tional Investor (RQFII) scheme, which allows a limited num- ber of international investors to directly trade in Chinese bonds and equities. Access to China’s equity markets for UK investors was further accelerated by the launch of the Shanghai-Hong Kong connect in 2014. This was followed by the Shanghai-London connect five years later. While the former initiative allows overseas investors to trade shares listed in Shanghai, the Shanghai-Lon- don connect initiative went one step further, allowing interna- tional investors to access A Shares outside of greater China for the first time. But the third, and perhaps most decisive factor, is the gradual inclusion of Chinese equities in emerging market indices since 2018, such as the MSCI. In 2019, 472 large and mid-cap China A share companies were included. Today about a third
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of the overall index consists of such equities, meaning that investors with passive emerging market investments have sig- nificant exposure to Chinese stocks.
As a result, Chinese equities have increasingly been integrated into institutional portfolios. For example, local authority pen- sion scheme pool London CIV has exposure to such assets through its £2.7bn Global Alpha Growth fund, which it launched in 2016 and counts digital retailer AliBaba as one of its largest holdings. It also has exposure in its £350m Emerg- ing Market Equity fund. Similarly, Border to Coast, another local government pension scheme pool, has appointed two China equity specialists to manage a mandate that could be worth up to £500m. Daniel Booth, the pool’s chief investment officer, explains that the inclusion of A shares in indexes has been a key factor in the decision to increase its exposure to China. “With the increas- ing weighting of China in the emerging markets benchmark, reflecting trends in the wider market, we felt it was appropriate to seek a specialist partner who will provide us with a local market presence,” he adds. Nest, the government-backed workplace pension provider, has almost doubled its allocation to emerging market equities dur- ing the past year, taking its exposure to around £930m, or 6% of its assets, from £480m.
The surge in inflows is driven by a broader demand for emerg- ing market equities rather than a focus on China in particular, believes Jonathan Vargas, an economist at the Institute of International Finance (IIF). He explains that while inflows into Chinese equities always tend to spike towards the end of the year, recent growth has been particularly strong. “We saw some $17bn (£12.4bn) of inflows into Chinese equities in the fourth quarter of 2020, which is significant,” he says. “But we believe it goes hand in hand with an overall increase of flows into emerging markets in general, independently of the asset class, so it is more of a systemic trend to watch.”
Dreamcatchers But investing in such a relatively young asset class is a risk, as the 2015/16 Chinese stock market crash illustrates. The Shang- hai and Shenzen exchanges surged by more than 100% in 2015, yet within a month the value of A shares listed in Shang- hai dropped by a third and more than half of companies halted trading.
A factor driving the higher levels of volatility is the dominance of retail investors, who account for more than 80% of A shares trading volumes across the Shanghai and Shenzen exchanges. This development has been encouraged by Chinese leader Xi Jinping, who has promoted retail participation in stock mar- kets as part of the “Zhongguomeng”, China’s dream of eco- nomic prosperity.
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