Measuring the impact of geopolitics on equity flows
Following the “candid and constructive” APEC meeting between Presidents Biden and Xi, investors are asking whether improving relations between the two countries can spark a market turnaround. In this note we try to measure how impactful geopolitics have been as a factor impacting Chinese equities. Have tensions impacted flows and valuations? Using data on global flows and positioning as well as comparing relative valuations between onshore and offshore a few conclusions can be drawn. First, with few exceptions, despite relations steadily deteriorating between China and the West over the last few years, global flows into Chinese equities have continued steadily until recently. Cumulatively since Q1 2020 over US$130bn of global investor flows were invested in Chinese equities, whereas by comparison roughly US$50bn have gone into Japanese equities and US$10bn into Indian equities. Periods around heightened tensions have slowed inflows or even driven short bouts of outflows but they have largely been short-lived. From a valuation perspective, it does appear that geopolitical risk events have impacted the relative valuations between offshore and onshore equities.
How much has geopolitical noise impacted foreign flows into Chinese equities? It turns out not as much as is commonly believed. Portfolio flows from global investors have ebbed and flowed, but it’s not clear whether U.S.-China relations have had a measurable impact on global positioning in Chinese equities. For example, foreign inflows into Chinese equities since the end of 2020 are cumulatively over $130bn USD and only recently has money started to leave, yet recent outflows only amount to roughly $10bn USD (see chart below). It is notable that U.S.-China relations have consistently deteriorated over this period but it did not coincide with material outflows. The surge of inflows during Covid followed by muted outflows raises the question of whether geopolitics have changed investor positioning, and if investor positioning hasn’t changed it challenges the view that a geopolitical improvement could drive significant inflows.
Are there observable trends in investor flows around geopolitical events? While flows briefly reversed during the Ukraine invasion, it was immediately followed by significant inflows on the eve of China’s opening from Zero Covid. Outflows have picked up in the second half of 2023 but it’s not clear whether declining U.S. relations were a factor. Periods of heightened tensions have not directly correlated to investor outflows. It’s far more likely that flows have followed macro conditions and expectations of future returns as the main factor.
Looking specifically at foreign investor flows, there was a surge of inflows in 2020/2021 that entered at the top of the market – and much of that money remains invested. While global fund managers are underweight according to most metrics, overall assets invested in Chinese equities through funds and ETFs have not reversed in a significant way. As such, if we see a substantial improvement in U.S.-China relations, it’s also unclear if we would see any significant further inflows. Considering the overall magnitude of flows in recent years it also could act as a potential overhang on rallies. For a market turnaround, any improvement in the geopolitical backdrop would likely also need to coincide with a material shift in global perceptions of China’s growth outlook, as well as a shift in perception of Beijing's policy clarity. In other words, a positive APEC outcome (or otherwise improvement in U.S.-China relations) itself is unlikely to be sufficient for a market turnaround, but a positive trend in U.S.-China relations, coupled with a more concerted supportive policy from Beijing – as well as broader improvement in confidence around China’s growth trajectory – would be impactful.
Have valuations been impacted by geopolitical risk events?
For Chinese equities, particularly MSCI China, global perception matters more than most. It’s important to make a distinction between onshore A-share Chinese equities and offshore Chinese equities listed in Hong Kong or the U.S., especially in terms of ownership structure. Chinese equities are unique among global companies in that the listed equities of many of its largest companies are predominantly owned by foreign investors, with little ownership by domestic investors. Take China’s internet giants as an example – the average ownership holding is approximately 90-95% global investors and 5-10% Chinese investors by nature of them being listed offshore and Chinese capital controls prevent onshore capital buying their shares. For onshore-listed equities, it’s the opposite where foreigners own only roughly 5% according to PBOC data.
If U.S.-China relations have been as big a factor as many believe, then theoretically offshore listings, which are predominantly held by global investors, would see their discount to domestic-listed companies increase as foreigners trim offshore Chinese equity holdings. The best way to look at this is what’s known as the A-H premium, which shows the valuation difference between onshore (A shares) and offshore (H shares) for companies that are listed in both Hong Kong as well as mainland exchanges. At the start of the trade war the onshore premium to offshore actually fell and has been stable since the start of the Biden administration, when U.S.-China relations started to more materially deteriorate. There is some evidence that offshore equities fell relative to onshore around risk-off events suggesting that geopolitical factors do have some impact on offshore valuations within a range (see chart below). For investors looking to avoid the volatility of global sentiment, domestic A-shares are largely unaffected by foreign flows and could more directly reflect the impact of supportive domestic policy.
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