China stocks are getting carried away (what isn't in the equity space?), but BlackRock Investment Institute is "warming up" to them. Following Monday's sell-off in the two big China exchange traded funds, investors may want to wait for a further pullback before getting in. But on balance, the global reflation trade will put a floor on Chinese equities, says BlackRock chief equity strategist Kate Moore.
"Progress on domestic structural reforms and undemanding valuations add to China’s attractiveness," Moore wrote in a global outlook report published this month. Worth noting, the FTSE China index looks cheap mainly because it is loaded with government owned banks and real estate. These are two of the most hated assets in China. Probably as a result of those two sectors, the percentage of global companies with a positive view on China has declined. By 2014, 76% of global companies surveyed by BlackRock Investment Institute had a positive view on China. It's currently around 70%, up from 65% at the end of 2016. In a way, China is witnessing a turnaround. The hard landing narrative guys, the ones who get all the TV time, will need to look for a new story for now. It's unlikely to scare investors.
China is reforming, it's investor base is becoming more professional, and BlackRock is placing their bets that there won't be a mind-boggling trade war, which is not to say that there won't be tariff increases here and there. No one knows for sure yet, and perhaps president Trump will give investors clues on this during Tuesday night's address to Congress.
Foreign institutional investors have historically been confined mostly to investing in offshore markets, namely Chinese companies listed in Hong Kong. That's what retail investors are buying when they buy the iShares FTSE China (FXI) fund. It's a more sophisticated set of investors there, who have years of long term investing strategy with tons of volume and serious institutional money. It's the near total opposite to the gambling den in Shanghai and Shenzhen, known as the A-shares market, which investors can access through the Deutsche Bank CSI China fund (ASHR).
Dual-listed large mainland Chinese companies currently trade at a near 20% premium to the A-Shares versus the H-shares in Hong Kong, according to Thomson Reuters data. This premium has roughly halved in the past year and BlackRock sees arbitrage here. They also expect it to erode further as trading programs allow mutual market access for investors between mainland and Hong
Kong exchanges, such as the now two year old "thru-train" known as the Shanghai-Hong Kong Connect.
China’s stock market is not easy to decipher. Corporate transparency is, well, not very transparent. Ownership is tied up in holding companies. There is very little analysis of A-share stock by trusted investment firms, which is why the A-share ETF is such a gamble. But that is changing and that is especially true among the new, entrepreneurial tech companies that are looking to be the next JD.com or Alibaba. These guys account for nearly half of the IPOs in the A-share market in 2016, according to Gildata and BlackRock data. Not that those companies are all worthy of investor dollars (they crashed hard in 2015), but they are something to behold and a testament to what China's new economy is building, privately.
These new-economy stocks now make up more than half of China H-shares – roughly the same breakdown as the developed-market MSCI World index. “Old economy” sectors such as materials, industrials and financials are still overrepresented in the domestic A-share market, BlackRock analysts say.
That picture is changing. Financials make up around 25% of the onshore and offshore market, according to MSCI data, after peaking at more than 40% in 2015. Foreign investors leery of owning shares in banks grappling with an increase in nonperforming loans, or highly leveraged state-controlled companies in old-economy industries, have alternatives if they go the route of active fund management. The indexes are going to be in these companies, no doubt.
Moore thinks China is still a neutral weight among institutional investors. "Over the medium term, we believe Chinese equities are an attractive – and under-owned – asset. Many of China's challenges are discounted in market valuations, and profitability is improving thanks to supply-side reforms," she says. China's ongoing liberalization of the financial system will gradually increase opportunities for foreign investors as well, with emerging market firms like Ashmore Group in particular being active in the fixed income space, expected to grow two fold over the next decade.
