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New opportunities in Chinese equities
CHINA'S equity market - the world's second-largest by market capitalisation - 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.
Increased access to the China A-share market may offer diversification benefits to global investors. The chart shows how A-shares have historically had a much lower correlation with global equities than broader emerging market (EM) stocks and Chinese shares listed offshore in Hong Kong (H-shares).
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.
MSCI incorporated 226 large-cap A-shares into its indexes on June 1, the first step in a process towards including 5 per cent of eligible A-shares by September. Foreigners previously invested in China mainly via H-shares and US-listed Chinese companies.
They held just 2 per cent 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 per cent from 30 per cent 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 under-appreciating 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 healthcare 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 US-China trade tensions, a rapidly appreciating US 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.