A new year in Chinese markets: Global investor allocations to China debt and equities set for continued growth
As Chinese New Year celebrations draw near, investor expectations for China’s equity and debt markets are set high for the Year of the Ox.
In January, China funds stormed ahead with eight of the month’s 10 best performing funds focused on China, according to Morningstar. The MSCI China index has risen 13 per cent since the start of the year, compared with a 4 per cent increase in the MSCI World index.
Investors are starting to consider upping their allocations toward China, according to Katie Sims, a senior investment consultant at Willis Towers Watson, speaking at an online briefing.
“China is the world's second largest economy, in equity and bond markets, but it is very under-represented in global investors’ portfolios. Typically, we see allocations between 3 and 5 per cent, whereas the market capitalisation of China is closer to 20 per cent,” says Sims.
While the gradual inclusion of China A shares on global indices such as the MSCI Emerging Markets Equities Index and FTSE Russell Emerging All Cap Index has already increased passive investors’ allocations, this trend is likely to keep going.
“If there's going to be a lot of passive money moving into an area, that's usually going to impact the prices, and so by investing before then we can certainly get ahead of the trend,” says Sims, who feels that 20 per cent exposure is “probably a very long-term target” for allocations.
“The way that we have approached it in our delegated portfolios is to set a near-term target of around 10 per cent of growth assets invested into China.
“In the fund that I run, that's just over 5 per cent at the moment and we are building towards that 10 per cent position over the coming years,” says Sims.
Index inclusion is picking up pace, with FTSE Russell planning to add Chinese government bonds to its World Government Bond Index (WGBI) from October 2021.
In China’s debt markets, portfolio manager of Ninety One's China Bond strategy Alan Siow says the government bond market offers depth, liquidity, and positive real yields.
“We think China offers a very compelling opportunity from a fixed income perspective, because it is the world's last large, deep and liquid market to offer both low correlations as well as positive real yields,” says Siow.
As of February, the China 10-year Government Bond offered a 3.2 per cent yield, compared to 1.2 per cent on the US 10-year Treasury.
“A lot of fund managers have to come to terms with the fact that if they ignore China, they’re now running an active risk.”
With daily transaction volumes in the region of USD29 billion, China now beats Japan’s bond market by 10 per cent. Still, the US bond market is by far the largest in the world with USD550 billion trading every day.
China is now emerging from a “self-imposed solitude”, creating opportunities for foreign investors. “China opening up its doors gives investors access to an economy that hasn't felt the touch of QE and negative rates,” says Siow.
The Chinese economy has continued to grow despite the Covid-19 slump in production, with official figures showing 2.3 per cent growth last year.
Growth is happening “perhaps a little bit too quickly”, says Siow, resulting in China’s central bank considering a rate hike, at a time when most countries are cutting in order to aid the recovery from the coronavirus pandemic.
Siow calls today’s China a “middle kingdom”. “Arguably, it was an emerging market, but even when it was fully within that camp it was not quite the same as other EMs. It's now in the middle because, as the RMB becomes more internationalised, it becomes a bigger part of bond indices as well as exchange rate reserve requirements.”
He adds: “As investors look at China, they need to divorce themselves from the idea that China is an emerging market, and think of it more as a developed market in waiting.”
When it comes to equities, Columbia Threadneedle Investments says that investors have been inundated for years with negative headlines about trade wars and international tensions.
Political tensions between the US and China have served to limit foreign investors’ options. In January, The New York Stock Exchange said it planned to delist three Chinese telecommunication giants, due to former President Donald Trump’s ban on US investment into firms with ties to China’s military.
“Ongoing US-China tensions have indeed impacted sectors of the economy, particularly in certain areas of technology. However, when one door shuts another opens, and there are parts of the economy, such as healthcare, which have never had closer international cooperation at both a corporate and government level,” say Dara White and Derek Lin from Columbia Threadneedle.
“What has been much overlooked is the significant progress China has made in developing its capital markets, which has made investing there more exciting than ever for foreign investors,” they add.
China’s fourteenth Five-Year Plan, which is due to be finalised in March 2021, centres around the idea of “dual circulation”, which aims to stimulate domestic consumption and self-reliance, while at the same time integrating China into the international community on trade and capital markets.
Healthcare is one sector that will benefit from this approach, says Columbia Threadneedle. On the supply side, White and Lin note that the Chinese government has already started expediting approvals for new drugs and allowed pre-profit biotech start-ups to list on public markets. It has also allowed 80 internationally developed drugs from global biotech giants to be licensed in China, compared with just 10 or so in 2014, while “out-licensing” of Chinese drugs has also increased.
“Naturally, investing in drugs and medical devices directly presents a huge opportunity,” say White and Lin, but they also note that investing in contract manufacturing organisations (CMOs) or contract development and manufacturing organisations (CDMO) could be another way to play it. “Using a gold rush analogy, if the biotech’s are gold miners, then the CMO/CDMOs are the shovel makers who will win regardless of which miner uncovers the gold.”
Mike Shiao, chief investment officer of Asia ex-Japan at Invesco, says 2021 is poised to be “another fruitful year” for Chinese equities, thanks to higher visibility surrounding the growth outlook and an increase in allocation to the asset class.
“Today’s market is led by a narrow group of few large-cap stocks, but an increase in allocation to the asset class will allow investors to tap into a greater number of stocks, some of which are yet unknown and hence are unique value-added sources,” says Shiao.
Shiao says one major opportunity is in the realm of ESG investing in China. The focus on ESG has been growing rapidly in China, with 48 per cent of the MSCI China companies issuing ESG reports in 2020, compared with only four per cent back in 2013.
“We see more investors having a dedicated China allocation given its growing size and breadth of opportunities while, at the same time, environmental, social and governance (ESG) considerations are expected to gain traction,” says Shiao.
China has pledged to reach carbon neutrality by 2060, and regulation is also expected to tighten as the China Securities Regulatory Commission (CSRC) publishes guidelines for mandatory corporate disclosure on ESG issues this year.
Pruksa Lamthongthong, co-manager of Asia Dragon Trust, says that there are opportunities in renewable energy as China commits to a greener and lower carbon future, and curbs its dependence on fossil fuels imports.
“This presents long-term investment opportunities in the renewables supply chain that supports industries such as wind power, solar power and electric vehicles. Many of the companies within this renewables value chain are located in China."
"With the Asia Dragon Trust, we have exposure via Yunnan Energy New Material, the world’s largest maker of lithium-ion battery separators for electric vehicles; Longi Green Technology, the world’s largest solar wafer maker; and China Resources Gas, one of the top city gas distributors, with the growing share of gas in China’s energy mix supporting its prospects,” says Lamthongthong.