China – Feature
A consequence of that is A shares trade at a premium to H shares as retail investors have driven up prices. Moreover, with retail investors focussing less on company valuations, the mar- ket is relatively less efficient. But this could be an opportunity for investors. An active manager with sound knowledge of the local market might be able to identify companies that have been significantly undervalued but have so far not been on retail investors’ radars.
A shares also offer institutional investors access to a broader spectrum of opportunities, in terms of sector allocation and overall stock count. While H shares provide exposure to a uni- verse of less than a 1,000 stocks and sectors such as interna- tional banks and tech, the A shares spectrum covers some 3,500 companies with sectors ranging from domestic con- sumption to financials, media and leisure, overwhelmingly in the form of mid or small-cap companies which tend to have limited analyst coverage. Indeed, around a third of A shares currently have no analyst coverage. The IIF’s Jonathan Vargas argues that the growing inclusion of Chinese equities in emerging market indices means that capi- tal flows will become more stable and there is not going to be as much rent-seeking behaviour. “Investors are less likely to go in and out of the asset class,” he adds. But the key factor driving institutional bullishness on China is the pace of its recovery from the pandemic, which has fuelled a positive macro-economic outlook, he says. “Viewed from a macro perspective, we are seeing a healthy balance of pay- ments and growth forecasts of around 8%, which you are not going to see anywhere else in the world, apart from some Sub- Saharan economies,” Vargas adds. “A lot of this is because China was able to recover from the pandemic so fast, while many developed markets are still struggling.” This is also a key reason for Nest’s increased interest in the world’s second largest economy, as Edoardo Cetraro, invest- ment analyst for the defined contribution (DC) scheme, explains. “After the initial virus outbreak, China managed to effectively control the pandemic while many developed mar- kets countries are still struggling to contain it. Despite most of the world’s economies contracting significantly in 2020, China displayed strong economic resilience,” he says. Cetraro ties this into the long-term trends for the region, which counter the trajectory of many developed economies “Over the next 10 to 20 years we expect China’s urbanisation rate to rise further – about 40% of the population live in rural areas. This presents opportunities to invest in companies that can profit from a rising middle class and outpace similar companies in developed markets.”
Challenges But strong economic forecasts do not guarantee a challenge-
free investment, Vargas warns, adding that investors in China will continue to face several obstacles.
“The biggest risks investors in China continue to face are the trade stance of the new US administration and regulatory intervention by Chinese authorities,” he says. Incoming US treasury chief Janet Yellen has already indicated that she does not intend to diverge significantly from Trump’s hostile stance towards the People’s Republic, by describing China as the US’ “most important strategic competitor”, an indication that the Sino-US trade relationship will remain tense. Another financial risk for those with exposure to Chinese equi- ties comes not so much from the firms they are accessing through share purchases, but from risks in other asset classes. Credit risk is a prime suspect here. Since the global financial crisis, debt-to-GDP ratios in China have doubled, with corpo- rate borrowing a key driver. Unlike US stock markets, which rely heavily on equity financing, only a fraction of corporate financing in China is funded by equities. Instead, Chinese firms rely on bank loans and earnings to fund their business. While this makes the underlying businesses less vulnerable to a short-term stock market crash, a credit crunch could poten- tially be more painful.
In addition, real estate in China is also showing signs of over- heating, a trend which in the past has had severe knock-on effects for the health of the economy. ESG risks also remain high on the agenda of institutional investors seeking exposure to China. This ranges from labour rights and the treatment of minorities, such as the Uighur pop- ulation. For Akademiker Pension, Denmark’s retirement fund for education workers, these concerns have been far reaching enough to commit to selling all of its Chinese bonds and equi- ties, amounting to a divestment of more than €50m (£36.5m). So far, no UK scheme has taken an equally drastic stance, but ESG risks around Chinese equities remain on their radar, as a Nest spokesperson acknowledges. For the auto enrolment pro- vider, a key challenge remains how to combine increased expo- sure to the Chinese economy with the aim to become carbon neutral by 2050.
Despite these challenges, Vargas remains optimistic that China will be in a much better state to weather the challenges of the pandemic than many developed markets. He argues that one key appeal of Chinese equities continues to be in its sector composition and attractive equity valuations compared to developed markets.
“China increasingly has its own legs to stand on, and as such will be less affected by global trade challenges or a taper tan- trum that could hit other emerging markets. Yes, there will still be volatility, but this time it could be more manageable. In the end, investors will have confidence that China will always be China,” Vargas says.
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