Jared Gross: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on China. And has been recorded for institutional and professional investors. I'm Jared Gross, Head of Institutional Portfolio Strategy, and guest host of the Center for Investment Excellence.

With me today is Gabriela Santos, Global Market Strategist. Welcome to the Center for Investment Excellence.

Gabriela Santos: Thank you so much, Jared. Great to be here with you all.

Jared Gross: Thanks, Gaby. So today we are really excited to discuss a topic that is crucial for institutional investors - China's role in the global economy and its role within their portfolios. Gaby and I are going to discuss the maturation of China's economy and the integration of Chinese assets into institutional portfolios.

There's been a lot of news recently with respect to the Chinese equity markets. But before we get there, we want to explore China's role in the global economy; its development as a nation; and the development of its financial markets as a precursor to understanding where we go from here. So let's start at the beginning.

When China's economic growth began to really take off in the early 1990s, people started to take notice and started to contemplate how they should be addressing China as an investment issue. So Gaby, how has this evolved over time and where do you see the Chinese economy going today?

Gabriela Santos: It's absolutely incredible, Jared, to think back to 1990. Where was China 30 years ago? It was the eighth largest economy in the world. It had a GDP per capita of about $700, very low income. And it had 0% of its population in the middle class. In terms of drivers of growth, it really was primarily agriculture and manufacturing.

What happened over the following decades was really incredible. China began opening up its economy to private enterprise, to the rest of the world, and it really shifted its economy from agriculture to manufacturing. To do so of course, it invested a lot in the capital, the skills that it needed to make that transition, and to really reap the benefits from those efficiency gains.

Of course, China got an added boost from joining the World Trade Organization in 2001. And overall, from 1990 to 2010, China had an average growth rate of 10%. And it's incredible to see where it sits today. It's the second-largest economy in the world; GDP per capita of $10,000 so it's middle income; 40% of its population now in the middle class. Tremendous. Tremendous.

Of course, its growth rate has naturally decreased over the past let's call it five years or so. It's only had an average growth rate of 6.8%. In terms of where it's going and that's always the most important thing, not where China is today, where it's going next quarter, but where does it see itself going the next five, ten, 15 years? And it has a plan for that in its five year plan, and we're in the 14th five year plan.

Over the next five, ten years, China wants to become the largest economy in the world. It wants to double its GDP per capita. And it wants to add nearly another half a billion people to its middle class, getting to about 70% of the population. In terms of drivers, it'll probably become an economy more and more driven by services, more by domestic consumption and innovation.

And China knows, it can't reap the same efficiency gains it did for the last 30 years. It needs to really focus on innovation and skills to be able to continue being a high productivity economy. And we do think ultimately, China will continue to slow structurally, but it will remain an engine of growth globally, and continue to grow at a potential growth rate of 4-1/2%, which is, of course, significantly higher than what we envision to happen in the US, which is much closer to 2%.

Jared Gross: Yes, 4-1/2 would certainly be a growth rate that almost any other economy in the world would gladly trade for. Maybe just to jump off on a side topic here, we've obviously been going through COVID recently. We've seen the very sharp decline and rebound in US economic growth. People may not be quite as clear on how China has weathered the storm. Certainly it seems like their very aggressive policy response was effective. But how has COVID affected the Chinese economy?

Gabriela Santos: Yes. And China did have, of course, it's where the pandemic began, of course, and it did have a zero-tolerance approach to COVID, which meant it really wanted a minimal amount of domestic cases, and it wanted a minimal amount of fatalities. And it was willing to use very aggressive tools to get there, right?

It closed its borders to foreigners. It utilized very intrusive surveillance measures. And it implemented very strict quarantine and activity restrictions whenever cases flared up. Interestingly, it had a lot of success with that approach last year. Of course, it was painful once it was first implemented. China did go through a recession in the first quarter of 2020. First negative year-over-year growth since 1990.

But it ended up controlling cases domestically. China went back to normal. Second quarter, China staged a full V-shaped recovery and was back to pre-pandemic levels by end of June of 2020. So, first in, first out, very quick recovery and has been growing for over a year, at this point. Now it continues with the COVID Zero strategy, which is proving to be a bit more difficult this year because of the spread of the Delta variant, as well as some initial hiccups in the pace of its vaccination.

So China is still seeing some impacts from some localized restrictions on activity, combined with some tightening they were doing earlier in the year in terms of monetary and fiscal policy. China is having a bit of a cyclical slowdown here in the third quarter. It might not grow at all in the third quarter on an annualized basis. But we do expect it to pick back up in the fourth quarter and beyond, and go back to those structural drivers, as it provides some policy support and as it's able to move on permanently from the pandemic.

Jared Gross: That's great color. Thank you. So pivoting to the Chinese financial markets, you articulated this case of this very long, powerful growth trend from agriculture to industry to services, from export-led growth to domestic consumption. And the Chinese financial markets have to some extent followed along that path. But one of the things we observe externally is that the ability of investors to access the Chinese markets has been somewhat limited.

And the capitalization of the Chinese markets is still probably disproportionately low relative to their GDP weighting in the global economy. So talk to us a little bit about how you've seen the markets evolve kind of alongside the economy and where we are today.

Gabriela Santos: Yes. So the growth of China's local markets and here, thinking about equity and bonds, has been a bit more recent than the development of their economy, per se. And I think if we just go back a decade and we think about where the markets were back then, they were very, very small; $4 trillion dollars in market cap on the equity side, $3 trillion dollars on the bond side. But that was ten years ago.

At this point, the equity market has grown three times. It has a market cap of $12 trillion. And its bond market has grown sixfold with a market cap now of $19 trillion. And that really puts markets as the second largest in the world in China, both on the equity and the bond side, only lagging behind the US. So tremendous, tremendous progress. There's still a lot to come going forward.

In terms of size, its equity market is still only a quarter of the size of the US. And its bond market is still only about a third. So there's a lot to do to still grow these capital markets. And China implemented reforms last year which might have gotten lost in the pandemic noise. It implemented new securities laws, for example, to try to grow its equity market. So it implemented an IPO registration-based system to allow it to become easier, more transparent for companies to go public in Chinese local markets.

So we should see that help the growth of its equity market. It's also about the actual development of the structure of the market itself. The equity market is still very retail heavy. Retail investors are 80% of equity market trading. So China's also implementing reforms - wealth management reforms, for example, to try to institutionalize that market more; to have it be a bit less sentiment-driven, more fundamental-driven, and less volatile over time.

And the bond side in terms of structure, it's still very much a market dominated by domestic banks by buy and hold investors. So liquidity is really thin. And China is also implementing reforms related to these asset management reforms to get different types of investors participating in the bond market that can help improve liquidity.

And the last thing I'll mention about these markets is really over the last five years or so, it's become a lot easier for foreigners to also access them, right? It was back in 2014 China launched its first stock connect program linking Shanghai and Hong Kong and the rest of the world. And that makes it a lot easier for foreign investors to buy really a large chunk of domestically listed Chinese companies.

And then a few years later, 2017, China launched the bond connect program to allow also foreign investors to buy local currency bonds a lot more easily. And with that, index providers started including A eight shares as well as Chinese local currency bonds into the indices. And now China's 40% of MSCI EM and 8% of the global Bloomberg/Barclay's Ag. Still not the right weight, we should point out.

Jared Gross: Well, and I think you touched on an important issue, which is the institutionalization of these markets is what will ultimately make them attractive to foreign investors, at least at the institutional kind of portfolio level. And maybe if you could comment a little bit on the mechanisms by which foreign investors have accessed China.

You mentioned some of the structural reforms that have made it easier, but obviously, most investors are going through managed funds, maybe not so much direct accounts, and having kind of intermediaries handle this on their behalf. What are you seeing in terms of the mechanisms by which US or European or other developed market institutional investors are allocating capital into the Chinese markets?

Gabriela Santos:    What we see is when we look at certain surveys, we actually see that some investors still have no exposure to these local markets, the A share equity market or the local currency bond market. A recent Cambridge Associates survey showed that global investors benchmarked to the (AKWE). About a third of them had just no exposure to local markets, so still a significant share.

In terms of the exposure, we see investors having, it tends to be - it's part of a broader emerging markets allocation, so allocation to what's included within what MSCI defines as the EM equity universe and China's role within that, as well as what index providers, whether it's Bloomberg/Barclay's or JP Morgan, consider to be a part of the bond side for emerging markets.

And it's really interesting because we mentioned at the onset that the weighting of these local markets and of China overall, is still not the right size. So what that means is that actually, some investors have no China and even investors that have that EM allocation to China, still don't have enough; still don't have the right size.

Jared Gross: Well, and let's just take a jump off from there and get into the internals of these markets a little bit, because I think that's also very interesting. When you look at the distribution by economic sector or in corporate sectors, there's quite a bit of difference between the offshore Chinese markets and the types of companies that are represented there, and the onshore Chinese markets.

And it seems that as the economy evolves and diversifies and becomes more about consumer demand and services and internal consumption, many of those sectors that have prospered in the offshore markets may become less meaningful. And some of those sectors that are predominantly represented in the onshore markets, the A share market, are going to become even more important.

And so maybe speak to that a little bit and how that weighting challenge that the MSCI model has sort of forced investors into, maybe leaves them underexposed to certain key sectors.

Gabriela Santos: Yes. That's a really good point, because investing in Chinese equities is a bit of an alphabet soup. And for a long time investing in Chinese equities meant just investing in companies listed in Hong Kong or in the US Stock Exchange, so A shares or ADRs. It was really only mid-2019 that MSCI started including A shares because of the stock connect program and all these improvements of opening up to foreign investors.

But it's interesting, the weighting of A shares is about 5% within MSCI EM today, but that's not the right weight. MSCI is only giving a 20% inclusion factor to A shares. If it really gave it the right size A shares should represent about 20% of MSCI EM. And that does lead to, I would say, two distortions in portfolio allocation to China.

The first is sector. As you mentioned, the A share market, the ADR market, the offshore market does tend to have some more representation of old economy sectors like banks, industrial companies, some old school traditional energy companies versus the A share market tends to be more dominated by new economy sectors. So exactly, domestic consumption, technology, and the like.

And that's only going to increase, right, with these new IPO measures, with the pull that China is making for new innovative companies to be listed domestically. So whether by choice or not, it's likely that these new economy sectors will grow and grow in representation domestically. So if we want exposure to these exciting growth themes, A shares is the way to go. And portfolios at the moment are structurally underweight those kinds of sectors in China.

And the other one is from a portfolio construction standpoint. A shares have something else to offer, which is very low correlation to other markets. So 0.4 correlation to the S&P 500, 0.5 to EM. So there's a benefit of having a more local-driven market, is that it beats to the sound of its own drum. Right? It moves based on China, sometimes for the bad, sometimes for the good. So it helps with also diversification.

So just having that EM or that passive allocation to China does end up leaving investors underweight the exciting growth sectors, and also missing out on some portfolio construction benefits.

Jared Gross: Yes. I think the correlation issue is key because if you look at correlations between the broader global markets and say US markets, if you're a US-focused investor, the broader (AKWE) is highly correlated to the US. Even (AKWE) EM is relatively highly correlated. It's almost a .8 correlation. And the China index, as defined by MSCI, is better. It's about .6.

But it really gets better when you go down into these A shares. And given the structural underweight that you've described, investors are missing out on some of that benefit, not just from the bottom up opportunities that you're talking about, to get into some of these more exciting growth opportunities coming out of China, but simply to diversify their portfolios and have a meaningfully uncorrelated source of return, which is not that easy to come by.

And so the cure, I suppose, in the near term at least, until the MSCI benchmarks are perhaps more rationalized, is to run a dedicated onshore, A share-type investment strategy in parallel to what is typically an MSCI style emerging markets benchmark.

Gabriela Santos: Exactly. To be able to actually rightsize China's local market size and reap all those benefits. And the last thing I'll say is maybe the correlation rises a bit over time as you get more foreign participation. But it's really unlikely to rise to the kind of levels that we see in the US. For example, with global markets, because China is still very much its own engine of growth, it goes through its own economic and policy cycles, its own reform cycles, so that diversification benefit is unlikely to change very soon.

Jared Gross: Well, I think when I've spoken to clients over the years about investing in this direction, I think there has always been a hurdle to get over, which is the inclusion of China within the broader emerging market space. And for many decades, investors have been in and out of emerging markets. And there's certainly some scar tissue over previous crises, not so much in China, but in other parts of the emerging markets landscape.

And, you know, the returns have been choppy. They've tended to be very positive at points in time, but there's also been a lot of volatility. And I think to some extent that exasperation with the broader emerging markets categories, has impacted investors' willingness to invest in China directly. And so I think this idea of maybe listing China out of those EM-focused benchmarks a little bit, is an important theme for, if not the past ten, 20 years, certainly for the next ten, 20 years.

And maybe I'll ask, is that something that you hear about that China, you know, because of its status as an increasingly developed economy, will at some point sort of graduate from these EM benchmarks and start to operate on its own?

Jared Gross: So I think there's the question of whether the benchmark providers get there. And we haven't heard anything from MSCI in that regard. Whether it's about rightsizing the share allocation, has no plans to get there at the moment anyway, or about breaking out China from the EM benchmark.

But I think what we're hearing from institutional investors is they're getting there on their own without waiting for the benchmark provider. And as you mentioned, thinking about taking on dedicated A shares (unintelligible) to rightsize China, to get those return, as well as diversification benefits. And I think on the bond side, we're still in early days of that process.

It's a market that started opening up more recently. And as a result, maybe for investors at this point, it still makes sense to get the allocation to Chinese bonds more through a broader emerging market debt allocation. But perhaps with an active, flexible EM debt manager, right, that can actually give China the right size and can really think about some of the benefits Chinese bonds provide, which are higher yield pick up, as well as low correlation as well to other markets, but also taking into account some of the risks.

The yield curve does move. There's credit risk. And of course, there's the currency component as well.

Jared Gross: I think you've hit the nail on the head there. I think in terms of fixed income, the relative impact of some of those other risks, whether it's curve rates, currency and so forth, can overwhelm the yields as attractive as they are. And I think it is true that the Chinese fixed income markets do offer on a credit adjusted basis, a very attractive level of yield compared to most other EM and even some developed sovereigns.

But yes, I mean those yields are still relatively low in the context of history. And I think we have to be careful about piling in too aggressively there. So that's sort of more diversified, active approach within fixed income, is more typical and probably will remain so. Whereas I think, to your earlier point on the equity side, there is a bigger gap, I would say, in terms of the potential loss of future value, if you don't cure that Chinese underweight.

Because, you know, the upside from so much of that domestic growth, is going to be missed out on. And I think that's really what it comes down to, is finding sources of growth and positive return in this kind of low return world, are challenging enough. And when you survey the global economic landscape, China clearly stands out as an engine of growth for the next decade or decades. And to be underweight that sort of economic engine just does not feel like the right place to be.

Gabriela Santos: Absolutely. And I think eventually we'll get there on the bond side as well. But at the moment, I think that's a process that's a bit further behind the discussions we hear with equities, which are much more advanced at this point.

Jared Gross: So maybe that brings us back to current events. And obviously, in the last few weeks and months, there have been a series of headlines coming out of China, with respect to, broadly speaking, the regulatory stance of the government towards various either individual Chinese companies or sectors within the Chinese markets. I think that's created some consternation among investors, who maybe felt blindsided by some of those moves.

Although we can argue as to how blindsided they should have felt, given that the Chinese government does actually tend to telegraph some of these things a little bit. And, you know, it has potentially raised some questions about sort of investability going forward, if we've now introduced this sort of wild card of sovereign regulatory risk, how comfortable do we feel owning the Chinese equity market? And so walk us through your thoughts on that and particular, where you see the weight of regulation falling in terms of sectors and onshore/offshore markets.

Gabriela Santos: Yes. So I think this recent episode of regulatory tightening cycle we're in, first of all, to answer the question, yes we still believe China's investable, and all of the arguments we made previously still hold. But two things that are important takeaways from this - I think number one is there are also downsides to investing in China, and it does come with higher volatility. And the second one is really the need to be very active in China and not just by choice, but by necessity.

Overlaying investing in China with ESG considerations is also a risk management exercise at this point. In terms of backing up that argument that China is still investable, I think rather than looking at each regulation as an individual random headline, I think we should really put it together as a piece in the broader mosaic of what China's trying to do here.

And it really is trying to use regulation to make sure that the quality of growth remains higher than it used to be. So really, to focus on domestic demand and tech innovation. And tech innovation for China is not social media apps or apps in general. It's hard technology like 5G, AI, semiconductors. So a difference between regulations of the internet sector versus very loose support of regulations of hard technology.

It's also aiming to improve more and more the quality of life for Chinese people, right, and that really focuses on regulations that protect workers and customers and suppliers, and also regulations that help to lower the cost of living, especially prices of things like education and healthcare, as well as housing prices. So that's ultimately the plan here. And in line with what we started about what China's plan for the next decade is for its growth.

But it doesn't mean China wants to completely rethink the role of private enterprise, private capital, and foreign investors. They still need those in order to accomplish these goals. And that's really the message that China is trying to deliver to investors, is it's not a complete rethink of the role of private capital. It's really just putting it in context.

Ultimately, of course, balancing profit and social goals, I think it kind of caps margins for some companies in China. But you still have the offset of very high revenue growth potential for new economy sectors. So, net/net you can still have an attractive return for Chinese equities in a pickup over developed markets.

Jared Gross: Well, I think that is just a healthy reminder that the Chinese government engages in economic planning on a time horizon and cycle that we, you know, here in the United States or in most western economies are not accustomed to. And that very long-term approach, while it may result in some inefficiencies, they may not have their aim squarely on target in all categories, it really does inform everything they do.

And as you said, in certain sectors it probably caps the upside, because they simply won't allow certain activities to grow too big too fast. But stability over the long horizon is really the goal. And, you know, I think maybe in concluding, that's something investors should be mindful of as well, which is you have to think about China as a long-term investment.

You are playing the long game to take advantage of this growth and development story that although it has been going on now for 30 plus years, is still probably only in the middle innings. And there is lots to go. And so there will be hits and misses here. But the decision to be exposed to China as a long-term investor, is a pretty critical one, and something I think investors really need to get right.

So maybe with that, we can wrap it up. And I will say, Gaby, thank you so much for joining today. This has been a pleasure. And thank you very much.

Gabriela Santos: Thank you so much Jared, for having me. Thank you, everyone, for listening.

Man: Thank you for joining us today on JP Morgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you very much. Recorded on September 15, 2021.

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