China’s economy has enjoyed explosive growth during the past 30 years. Now the world’s second-largest in nominal terms after the U.S., China currently contributes around 15% to global GDP. And in the next three years, says the International Monetary Fund, the country could account for more than a third of global economic growth. See “China’s on the rise,” below.

In fact, the country is such a big player in the global economy, that Jan Dehn, Portfolio Manager at Ashmore Group has told us: “The largest risk is to not be invested in China."

China is on the rise

Forecasts expect the country’s contribution to global economic output to increase—dramatically. Source: Schroders. Data as of March 2019.
Line chart showing China’s GDP growth from 1970 to 2019.
Yet its financial markets have still to take their place on the world stage up. Notably, they remain underrepresented in popular benchmark investment indices. For example, Chinese equities have just a 3% weighting in the MSCI All Country World Index. See “Playing catchup,” below.

Its financial markets are playing catch up

Domestically listed Chinese equities are underrepresented in benchmark investment indices. Source: Schroders. Data as of March 2019.
Pie chart showing the country composition of MSCI AC World Index as of March 2019.
Why? One reason: In the past, foreign investors had limited access to securities listed on China’s domestic exchanges, called “A-shares.” But that’s changing. During the past few years, the Chinese government has been opening this huge market as part of its plans to integrate with the global financial system and attract capital.

The country’s equity market capitalization warrant attention

China’s onshore and offshore stock markets combined are the world’s second largest. Source: Alliance Bernstein. Data as of November 2018.
Bar chart showing the equity market capitalization of the U.S., China, Japan, U.K., France and Canada as of November 2018.

China A-shares are stocks listed on both the mainland Shanghai and Shenzhen stock exchanges. These stocks represent more than 3,000 companies in a broad range of sectors, including traditional state-owned enterprises to some of the world’s most innovative businesses.

Foreign investors can now gain exposure to industries that were not previously available–such as Chinese white spirit manufacturers, including Kweichow Moutai, which is the most valuable liquor company in the world–ahead of Diageo, the producer of such well-known brands as Smirnoff, Johnnie Walker, Baileys and Guinness.

Making new connections

One of the most significant developments in the Chinese equities market is Stock Connect. First launched in 2014 between the Shanghai and Hong Kong exchanges and extended in 2016 to the Shenzhen market, Stock Connect allows mainland Chinese investors to buy Hong Kong and Chinese companies listed in Hong Kong. It also lets foreign investors buy China A-shares listed on the mainland using their local brokers and clearing houses.

MSCI acknowledged this development in 2017 by announcing that it would include A-shares in its equity indices. Other index providers are considering doing the same, including FTSE Russell, J.P. Morgan and Bloomberg/Barclays.

MSCI is increasing the weighting of domestically listed Chinese equities in three steps:

1) In 2018 it added 236 A-shares to the MSCI China Index, which made up 5%.

2) In 2019 the weighting of A-shares in the MSCI Emerging Markets Index will quadruple to 20%.

3) We’re expecting further increases in 2020, although MSCI has not yet confirmed details.

Adding mainland Chinese equities

MSCI’s process for increasing its weighting to A-shares in its indices involves three steps. Source: Schroders. Data as of March 2019.
Pie chart showing the three steps of MSCI increasing its weighting to A-shares in its indices.

China’s mainland stock markets are very liquid. But they also tend to suffer periods of turbulence, owing partly to a large number of retail investors with short investment horizons. Share prices can be volatile, as they tend to be driven by sentiment, behavioral biases and the latest news – making this one of the world’s most inefficient markets. As a result, it offers a large universe of potentially attractive investments for active managers。

As China’s stock markets become integrated into the global financial system, the number of stocks covered by research analysts is growing. (See “Sell-side coverage of A-shares” below). We believe the A-share universe presents an attractive universe for actively managed funds, with the skills and resources to identify opportunities and navigate the risks. Global investors are increasing their allocations to domestically listed Chinese equities, and the flow of capital continues to grow. (See “Stock Connect,” below).

Sell-side coverage of A-shares

The number of stocks covered by research analysts is growing. Source: AllianceBernstein. Data as of November 2018.
Bar chart showing the number of sell-side coverage of A-shares.

Stock Connect

South and northbound cumulative flows Source: Schroders. Data as of March 2019.
Line chart showing the Northbound flow into China A share from 2014 to 2019.
Moreover, we believe A-shares may offer higher alpha opportunities than many other emerging markets, including Chinese equities listed offshore. The market’s unique characteristics--including its breadth, liquidity and inefficiencies–favour an active approach. There is supporting data that shows the median active manager was able to outperform the respective MSCI index (See “Opportunities to outperform”).

Opportunities to outperform

Risk and return profile over a five-year period. Source: Schroders. Data as of December 2018
Chart showing the risk and return of MSCI China A Mercer Peer Group Median, MSCI China Mercer Peer Group Median, MSCI China Index and MSCI China A Onshore Index as of December 2018.

When constructing global portfolios, China A-shares may potentially offer investors diversification benefits because of their low correlation with the major developed and emerging equity markets, including China’s offshore market. China A-shares also offer opportunities to gain exposure to areas of the Chinese economy that are not available elsewhere.

We expect China’s domestic stock markets to increasingly integrate with global markets, so performance is likely to converge. This process has already been taking place, as illustrated by the gradual increase in the rolling correlation. (See “Diversification benefits”).

Diversification benefits

Chinese A-shares display low correlation with other equity markets. Source: Schroders. Data as of December 2018.
Bar chart showing monthly return correlation of MSCI China A share onshore and MSCI China with Asia ex-Japan, Emerging Markets, U.S., Europe and the world as of December 2018.

Source: Schroders. Data as of December 2018.
Line chart showing the rolling 36 months correlation of MSCI China A share onshore and MSCI China with MSCI Asia ex-Japan.

The Shanghai stock exchange is China’s largest. Most of the companies listed there are the large, state-owned enterprises (SOEs); most investors, are pension funds and banks. In contrast, the Shenzhen stock exchange trades shares of smaller, more entrepreneurial companies. These privately owned businesses are more innovative and more profitable than SOEs. Many tech companies are listed on the Shenzhen exchange, making it similar to the NASDAQ. Meanwhile, the Hong Kong exchange is dominated by the financial sector. (See “Sector differences”).

Sector differences

The composition of China’s main stock markets provides a range of opportunities for investors. Source: Bloomberg, MSCI. Data as of June 30, 2019.
Bar chart showing the sector differences among Shanghai Stock Exchange Composite Index, Shenzhen Stock Exchange Composite Index, ChiNext Index, Hang Seng Index, Hang Seng China Enterprises Index and MSCI China Index as of June 30, 2019.

Many companies are now listed on both the Shenzhen and Hong Kong exchanges. Stock prices are often substantially cheaper on the Hong Kong exchange than the Shenzhen. For example, it’s possible to invest in insurance company Ping An through H-shares or A-shares. Although the stocks are fundamentally identical, the ratio between share prices listed onshore and offshore has ranged from 0.80 to 0.95 in the past three years.

Given the structural differences between China’s onshore and offshore markets, we believe that investment managers can benefit from a combined approach. Maintaining the flexibility to move the portfolio around offers the opportunity to capture the investment ideas as well as the ability to protect returns when required.

If you’d like more information about the investment opportunities available in China’s domestic equity markets, please contact your J.P. Morgan representative.