A year of normalisation

China is making large strides to target foreign investors as a way to fulfill its domestic interests and global ambitions, becoming the world’s top destination for foreign investment in 2020. It has also staged a successful recovery from the COVID-19 pandemic versus other major developed economies.

In 2020, China surpassed US as the top destination for foreign direct investment, climbing 4% with US$163 billion ($210.8 billion) compared to US$134 billion invested in the US. This was a reversal of 2019 when the US attracted US$251 billion and China some US$140 billion. China was forecast to become the world’s largest economy by 2028, according to the Centre for Economic and Business Research (CEBR).

“For some time, an overarching theme of global economics has been the economic and soft power struggle between the United States and China. The COVID-19 pandemic and corresponding fallout have certainly tipped this rivalry in China’s favour,” the organisation said.

2021 also has the dual honour of being the first year in the country’s ‘14th Five-Year-Plan’ and the 100th anniversary of the founding of the Communist Party of China. Its goal to become a leading major economy would also help the country meet its target of becoming a ‘xiaojang’ – a moderately-prosperous society.

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The 14th Five-Year-Plan, developed during last year’s pandemic, prioritises the ‘internal cycle’ which aims to strengthen the domestic economy and reduce reliance on foreign technology and imported resources by doubling down on modernisation and technological innovations. It targets China becoming a ‘moderately developed’ economy by 2035 with a per capita gross domestic product (GDP) of US$30,000 which would be triple the 2020 level. 

Aidan Yao, senior emerging Asia economist at AXA Investment Managers, said: “China is actively promoting its assets to foreign investors to fulfil both domestic interests and global ambitions. 

“Domestically, increasing foreign investor participation, particularly that of institutional investors, in the onshore markets can help to improve market dynamics, reduce trading volatility (induced by high retail investor participation), enhance risk pricing and ultimately make the allocation of financial resources more efficient.

“Externally, increased holding of Chinese assets by global investors will help to internationalise the renminbi currency, making it an investment and reserve currency, beyond its role in facilitating global trade settlement.”

Jun Bei Liu, portfolio manager at Tribeca Investment Partners, said: “This policy has been planned far ahead but it takes a long time to get into place, the reforms were first talked about 10 to 15 years ago. They are good at giving forward guidance!

“Foreign capital inflows have been incredible in the last 12 months and in order to be successful, any economy needs to have capital flows and a capital-driven model.”

A-SHARES AND STOCK CONNECT

In order to invest onshore, foreign investors can buy A-shares which are the shares of mainland China-based companies that trade on the Shanghai and Shenzhen Stock Exchanges and are valued in renminbi. Previously these were only available to mainland citizens but are now available to foreign investors (albeit with a 20% monthly limit). 

In 2017, their status was further established when they were included in the MSCI Emerging Markets index. Including A-shares, China now accounts for 38% of the MSCI Emerging Markets index and 43% of the MSCI AC Asia ex Japan index. 

While China now represented almost 40% of the MSCI EM index, Wenli Zheng, portfolio manager at T. Rowe Price, said China’s dynamics warranted it having a larger weighting in the broader MSCI World index where it was just a 5% weight. 

“There is a big gap between China’s GDP and its weighting in the index, I think people will eventually see China as a separate class in the same way as we have Asia ex Japan as the dynamics in China are so different to other emerging markets.”

One of the first steps in its move to becoming a more open market for foreign investors was for China to introduce a Stock Connect system between the Shanghai Stock

Exchange and Hong Kong Stock Exchange in November 2014 and then expand this with a system between the Shenzhen Stock Exchange in 2016. The aim of the system is to allow offshore investors access to the onshore Chinese market which previously had only been possible by being a Qualified Foreign Institutional Investor (QFII) holder. 

In 2013, prior to the introduction of the Stock Connect, the percentage of equities held by offshore investors was 2% and this was now at 10%. 

Tim Campbell, chief investment officer at Longlead Capital Partners, said: “Average Northbound trading values [from Hong Kong to China] was US$20 billion per day in the first quarter of 2021, up 63% year-on-year.

“People are growing more familiar with the process and companies are being added which is helping penetration, it is incredibly successful and that will continue.”

Stephen Kam, portfolio manager at Schroders, said: “The Stock Connect has been a game changer when it comes to ease of access, it has opened up that accessibility and provided offshore investors with access to those sectors which were otherwise unavailable but that are domestic drivers such as white liquor and electric vehicles. That is what makes it interesting, it taps into that opportunity set of companies in that growth space”.

He said Schroders mostly used the Stock Connect to access Chinese shares but retained its QFII for now as not all stocks were available on the Stock Connect yet. Currently, only around 25% of total A-shares were available via the Stock Connect.

However, investors need to remember that A-shares can be more volatile than other major markets and many major Chinese companies such as Tencent are also listed as

American depositary receipts (ADRs) on US markets which are easier to access. Campbell added, however, regulatory change in the US was prompting companies to consider a secondary listing in Asia to protect themselves in the event of sanctions relating to the US/China trade war.

“The liquidity is not great on Chinese A-shares,” said Liu. “They are very interesting and easier to buy now but they are volatile.”

As of September 2019, 82% of A-shares were traded by retail investors and just 18% by institutional investors, a statistic which China was trying to change as it was creating an inefficient market. 

“For active investors, the A-shares market is immature relative to developed markets and trading volumes are driven by domestic retail investors whereas developed markets are more driven by institutional investors. More than 70% of daily A-shares volumes are retail but this means there are lots of inefficiencies created as retail investors move money around,” added Kam. 

ACCESSING CHINA

While China was the first country to be hit with the COVID-19 virus, it was also the first country to emerge and return to a positive stockmarket, making it an appealing destination for investors. 

As the virus took hold, China’s GDP was the worst in decades in the first quarter of 2020 with a decline of 6.8%. But by July, it reported GDP growth of 3.2%. CEBR said it expected China to average economic growth of 5.7% a year from 2021 to 2025 before slowing to 4.5% a year from 2026 to 2030.

“The outlook is positive for China as COVID-19 is well contained,” said Kam, “the economy is doing well, it is on a solid footing and momentum has been maintained.”

According to FE Analytics, the MSCI China index returned 18.1% during 2020 and the Shanghai Stock Exchange saw positive returns of 10.4% over the same period. This compared to returns of 1.4% by the ASX 200.

However, investors are being warned not to expect such positive returns in 2021 as last year’s figures were coming off a low base.

Kam said: “The market did so well at a headline level last year that valuations are elevated, that good news is priced in so will the earnings be good enough to support those high valuations? Overall, returns will be measured this year so if investors are expecting a blow-out year then they might want to temper those expectations”.

He suggested investors considered cyclical areas where valuations were reasonable compared to expensive areas such as e-commerce and healthcare. 

Zheng said: “The shift in economic growth drivers in 2021 is expected to drive a rotation in sector performance. While internet, technology and certain infrastructure-related names face the challenge of a high 2020 base, we think small caps, global trade-related names and services businesses should all benefit from the normalisation of the economy”.

There was also uncertainty regarding the well-known technology names Baidu, Alibaba and Tencent, the so-called BAT stocks, as they were currently subject to anti-trust legislation. These were perhaps the most well-known Chinese companies by foreign investors but the new guidelines put pressure on monopolistic practices and aimed to protect fair competition.

The State Administration for Market Regulation stated that the technology firms’ use of “data, algorithms, platform rules and so on make it more difficult to discover” what are monopoly agreements.

As a result, shares in the three firms were negative or flat over the six months to 19 May, 2021, with Baidu down 28%, Alibaba down 15% and Tencent up 1.1%.

Liu said: “Big technology is undergoing a regulatory reset and these always provide good buying opportunities but everything is uncertain so maybe it is better to wait for more clarity. But these companies have incredible business models so it is an incredible opportunity for investors”.

“These are very powerful businesses which are operating under Government scrutiny and have evolving business models which lack a clear regulatory definition, such as fintech, so we are still learning,” said Campbell.

Zheng pointed out the guidelines would apply to all technology companies, not just BAT stocks, “There will be more scrutiny in technology, similar to what is happening around the world where no one knows how to regulate it. The BAT stocks are in the spotlight but it is less dependent on a company’s size and more on whether they’ve built that business based on favourable treatment.”

For Australian investors to invest in China, according to FE Analytics there were six funds within the Australian Core Strategies universe which were predominantly focused on China specifically, four of which were actively-managed and two which were exchange traded funds (ETFs).

These were Fidelity China, Premium China, Schroder All China Equity Opportunities, VanEck Vectors China New Economy ETF, VanEck Vectors FTSE China A50 ETF and Vasco ChinaAMC China Opportunities.

There was also the option to invest in an Asia fund or a global emerging markets fund, which would still likely have a large weighting to China but be more diversified, or directly invest via a specialist brokerage. 

All commentators agreed, however, that investors would have a better chance at achieving outperformance if they invested via an actively-managed fund.

“Passive exposure can work for those who are cost-sensitive and not interested in outperforming the market. But we think active strategy is the best approach to invest in this market, given the level of market volatility, dominance of retail trading, onshore/offshore price discrepancies and inefficient risk pricing that still presents vast opportunities for active asset managers,” Yao said.

“It does not make sense to invest in A-shares via passive means, if you do the work then you can generate outperformance in China relative to the market. Whereas in the US, it is hard for active managers to beat the index,” Kam said.

“We have a view that positive economic growth doesn’t necessarily mean positive returns so it is important to focus on high-quality companies with strong management teams rather than taking a broad exposure.”