China: The Year Ahead
Stephen Ma, Head of Greater China Equities at BMO’s LGM Investments lays out the drivers for China’s booming equity market.
After an end-of-year rally in China’s A-share market following a robust northbound interest in the Shanghai-Hong Kong Stock Connect, fund managers are returning to a larger, more mature Chinese equity market.
For many years, although the A-share market has a large number of common stocks dually listed in Hong Kong and China, most offshore fund managers probably only knew a handful of quality A-shares that are uniquely listed in Shanghai. Blue chips, such as banking and energy companies, listed on both markets were well known, but when the Shanghai index suddenly spiked it generated global attention. Depending on how the rally pans out, for Chinese equities to successfully recapture the global investment focus, there is much work to be done. Viewed as a national aggregate, Chinese market capitalisation is not far below the US, but in terms of trading patterns, there is still a long way to go.
It is very difficult to quantify the extent it is improving and reaching international norms. There is significant information leakage versus other more developed markets, such as Singapore and Hong Kong or the US. Insider trading happens, but no one can prove it. The difficulty is that this caused a large portion of retail investors to give up on Chinese stocks for many years, thinking they can never beat the insider trading. Only recently has retail flow started coming back into the Chinese market.
Improvements in education and trading culture are needed before China reaches international market standards, but the five-year horizon remains positive.
Adjusting to retail
From a trading point of view, the return of retail flow is definitely good news. For example, daily turnover in an A-share can be double if not triple the H-share volume in Hong Kong, which allows us get in and to out with much less share price impact.
Nevertheless, the consensus amongst institutional investors is sceptical. In Shanghai’s A-share market, we have seen seven years of average markets, so there is reluctance to fully believe that China will recover. Many global investors are quite disappointed after several attempts to enter a bull market. With the interest rate cut of 40bps in late November fresh in investors’ memories, it is too quick to call the recent market upswing a trend. From a longer-term perspective, in one or two months Chinese equities merely regained what they lost over the past three years – we have yet to enter fresh ground.
Most China fund managers would say they spent the past three years scratching their heads at weak earnings despite the seeming strength in the underlying fundamentals. Part of the problem is that real interest rates are too high relative to the rest of the world, creating unfair headwinds for the Chinese economy.
If retail investors leave the market again for another seven years, then everything would be written off, and the market would revert to previous lows. The question then becomes, what triggered the increased retail appetite in the first place.
Decoupling from emerging markets
In terms of nominal GDP, China is number two, and the domestic A-share market now ranks second in market capitalisation, so it cannot be considered frontier. If, however, you consider it from a GDP per capita angle, China is still very much a developing nation, partially explaining why it still exhibits characteristics of an emerging market.
Valuation remains a real problem for investors. For example, a Chinese company listed in Hong Kong, can easily be 20% more expensive in Shanghai. For offshore investors, it comes down to our standard of valuation versus growth as to whether we decide to play that proxy, but a lot of smaller Chinese stocks have 25, 30, 35 times P/E ratios. For investors uncomfortable with that approach, there is no need to own those stocks, as MSCI China index, which is listed in Hong Kong, provides comparable exposure.
Through the third quarter of 2014, China was underperforming compared to the rest of the world including most emerging markets. When oil prices were high before October, many emerging markets benefited from lower energy prices and commodity prices. The recent correction in commodity and oil prices is good news for the Chinese economy.
Chinese banks are still trading at six times P/E, with a typical 6.5% dividend, placing them among the cheapest in the world. After this rally, they are still not expensive when compared even to other emerging markets or Japan.
Attracting institutional flow
Despite these attractive valuations, additional transparency is needed to induce more institutional investors to connect with Chinese equities. Regulatory and internal limitations have kept many institutional funds from using the Shanghai-Hong Kong Stock Connect, which would otherwise break down discrepancies between the A-shares and H-shares that have not had the chance to be traded out.
Our firm had similar problems and we are working aggressively with our internal team as well as external parties and clients to provide access. In the meantime, many firms use the RQFII program, but it does not offer the scale most investors desire.
If we can sort out this custodian issue, additional institutional trading will see the H- and A-share prices converge. There is no reason for the same stocks to be 20% different for the same company, which demonstrates international funds are unconvinced this current trend will last. After being burned multiple times, some fund managers are willing to miss the first quarter and will wait to get in during the second quarter if the rally continues.
We expect 2015 will be another unfortunately volatile year because China is so exposed to the rest of the world. Better quality, but economically sensitive companies, will still be relatively more vulnerable because the rest of the world is growing slowly or not at all. In this environment, it does not pay to be overly aggressive. In a tough year for equity markets, many good quality, economically-sensitive companies’ earnings and share price have suffered. We do not foresee another collapse, which means Chinese markets should touch bottom soon and then gradually go back up. Once investors regain a modicum of faith in the global economic outlook, investors who can pick the right Chinese stock should be rewarded accordingly.