As bullish foreigners pile into China’s stock markets and local investors remain bearish, who is right?
Nicholas Spiro says the inclusion of Chinese stocks on leading indices, plus cheap currency and interest rate changes, are drawing in foreign investment – but more domestic confidence is needed for a market recovery
Since its peak in late January, the Shanghai Composite Index has plummeted nearly 21 per cent, an even sharper fall than the one suffered by the main equity index in Turkey, one of the most financially vulnerable emerging markets.
As recently as September 14, the Shanghai Composite was trading below its post-bubble trough in January 2016 and stood at its lowest level since late 2014. While mainland stocks have rallied over the past fortnight, the severe headwinds bearing down on Chinese shares – the dramatic escalation in the trade war and a slowing domestic economy – remain firmly in place.
Yet, since the beginning of this year, investor sentiment in China’s equity markets has become remarkably bifurcated. While domestic retail investors, who account for some 85 per cent of the trading on the Shanghai and Shenzen bourses, remain resoundingly bearish, foreign institutional investors have been piling into mainland stocks.
According to new data from Bloomberg, foreigners have bought a net US$29 billion of onshore shares through Stock Connect, the trading link connecting bourses in China and Hong Kong, since the beginning of this year, a stark contrast to the capital flight in 2015-16 triggered by the surprise devaluation of the yuan.
Global funds are being drawn to China’s equity markets – the world’s third-largest after Japan’s – for a number of reasons, which include a local currency that is at its cheapest level against the US dollar since May 2017 and significantly lower costs for investors to hedge their portfolios against a further decline in the yuan, partly due to the rapidly narrowing gap between interest rates in the United States and China.
US trade war has little impact on Chinese growth, says Asian Development Bank
Yet the main catalyst for the surge in foreign inflows is the recent inclusion of mainland-listed stocks in benchmark emerging market equity indices, making onshore shares more accessible to passive and active global funds.
Last Wednesday, MSCI, the index provider, announced plans to increase the weighting of large mainland equities in its flagship index for developing economies from the current 5 per cent to 20 per cent of the companies’ free-float-adjusted market value. This will lift the weight of onshore shares in the index to nearly 3.5 per cent by May 2020 when mid-cap stocks are also included.
FTSE Russell, another leading indexer, announced its own plans last Thursday to add mainland shares to its benchmark emerging markets gauge in three stages starting next June, giving onshore stocks a 5.5 per cent weighting by 2020.
Persistent concerns about the regulation of China’s volatile equity markets call into question the merits of increasing mainland shares’ weighting in global indices – 48 per cent of foreign investors believe MSCI was wrong to include onshore shares in its benchmark index, compared with 27 per cent who back the decision, according to the results of a survey published by the Asian Corporate Governance Association in July.
However, the portfolio value of northbound trade through Stock Connect has nearly doubled since the announcement to include mainland stocks, according to MSCI.
Although the internationalisation of China’s equity markets has been marred by the outbreak of a trade war and the slowdown in the economy, the valuation case for onshore stocks has strengthened significantly and, as I have argued in previous columns, comes at a time when US leadership in global equities is under threat.
According to data from Bloomberg, the Shanghai Composite’s forward price-to-earnings ratio, a popular valuation tool, has fallen more than 22 per cent since June 2017 – when MSCI announced it would include mainland shares in its benchmark index – to 10.8, its lowest level since late 2014, the last time onshore stocks were cheaper than their offshore peers.
This provides a more attractive entry point for foreign investors seeking long-term exposure to China as part of an effort to diversify their portfolios.
Chinese hope for swift end to US-China trade war
Still, while foreign fund managers’ bets on mainland stocks could pay off handsomely if trade tensions ease or China’s economy starts to benefit from more aggressive stimulus measures, individual investors, who drive the market, need to become a lot more confident about the outlook for the country's equities in order for the market to recover.
Mainland traders, who are more sensitive to the adverse effects of Beijing’s deleveraging campaign and have been scarred by the 2015-16 crisis, remain sceptical that the market has bottomed. Chinese stocks had already declined sharply before trade tensions escalated during the summer, with privately owned firms at a distinct disadvantage against their large state-owned counterparts which benefit most from stimulus policies.
Yet, it is when China’s stocks are in a bear market that the support of foreign investors matters most. While lower valuations alone are not enough for sentiment to turn, increased foreign demand for Chinese assets helps shore up the yuan and accentuates the differences between the current sell-off and the panic of 2015-16.
Nicholas Spiro is a partner at Lauressa Advisory