Despite the well documented macro-economic headwinds facing China, we believe investors do not have enough exposure to equities of one of the largest economies in the world, in particular onshore Chinese equities.
We’ve found that the average international investor’s total China exposure is 4.0% of its total assets1. A large part of this is likely to be in offshore Chinese equities through emerging market (EM) equity strategies benchmarked to the MSCI EM Index. While China accounts for around 21% of the MSCI EM Index, down from a peak of close to 40%, the weight of onshore Chinese equities (China A-shares) is only about 4%.
However, judging from prior examples of Taiwan and Korea, we expect that onshore Chinese equities will continue to rise in global indices.
1. We see onshore Chinese equities delivering high single digit annual returns over the next 10 to 15 years
In our 2024 LTCMA, we shaved our forecast in local currency from 9.5% to 8.9% ,9.1% in Euro and 10.8% in US dollar terms2. These are generally higher than both our emerging and developed market equity returns assumptions.
We reflect the improving sectoral mix of China’s equity market towards technology and consumer sectors, with higher margins. However, net dilution continues to be a material headwind, reducing our long-term earnings per share forecasts. Given the relatively depressed state of the market, valuations provide a boost to returns this year. Currency is also a notable tailwind, particularly in USD terms.
Among the key factors that could further affect our long-term assumptions for Chinese assets are: the pace of structural reforms; policies seeking to rebalance efficiency and equality in the economy; liquidity; and the external environment.
2. Onshore Chinese equities present diversification benefits
Chinese onshore equities have historically had a low correlation to other assets, presenting investors potentially attractive portfolio diversification opportunities*.
Correlations will likely rise as foreign investor participation in the Chinese market rises, however, we believe correlations will remain low relative to developed market assets, given China’s distinct economic and policy cycles. We anticipate a gradual recovery in consumption in 2024, even as the real estate sector poses ongoing headwinds, reinforcing China’s idiosyncratic market environment.
Many investors do not differentiate between offshore (Hong Kong-listed H-shares and US-listed ADRs3) which are more correlated to global markets and onshore A-shares. 2021 was a stark reminder that these markets can diverge. Offshore equities were hit by concerns over forced delisting of ADRs – onshore equities rarely have ADRs – and regulatory change that primarily impacted mega-cap offshore stocks. In contrast, onshore equities delivered positive returns, albeit more muted than global equities, as China tapered its stimulus. Then in the final quarter of 2022, onshore China lagged MSCI China by close to 10% as offshore equities responded more positively to policy support for the real-estate and tech sectors, and the prospect of an end to zero-Covid.
We modelled Chinese equities’ return projections, their correlation to other markets and volatility risk based on historical data. A dedicated allocation to A-shares of up to 10% over and above current benchmark index weights would result in a more optimised portfolio with an improved efficient frontier — which means A-share investors can expect higher returns for each given level of additional risk. Put another way, with global equity correlations high, not having adequate onshore exposure may represent an opportunity cost in terms of portfolio diversification*.
3. Onshore equities provide exposure to China’s increasingly consumer-led economy
China’s equity market is shifting towards sectors that are benefiting from its transition to a more consumption and innovation driven economy, and away from sectors that are more reliant on investment and exports. The beneficiaries of China’s economic transformation include consumer goods, technology, health care and high end manufacturing. We expect these shifts to continue, potentially offering China A-share investors more exposure to these high growth sectors compared to emerging markets overall.