Structurally, these are historic times

Yet the world’s second-largest economy is going through a period of rapid and profound change. China is seeking to become better integrated into the financial system by opening its capital markets to foreign investment and encouraging its companies to invest abroad at a time when it is moving from fixed-asset investment to a consumer-based economy.

As we have seen in recent months, this rapid rate of change is likely to generate significant volatility and uncertainty. However, as these adjustments play out, there are wealth of opportunities to uncover for investors who are prepared to take a disciplined, bottom-up approach with a long-term horizon.

China’s stockmarkets have significant growth potential and that expansion will be propelled both by domestic investors and foreign investors.

Looking first at domestic investors, Chinese households hold far greater proportions of their savings in cash and less in stocks than the global average. This situation looks set to change considerably.

As a result of this shift, valuations should rise as more of these domestic investors allocate a greater proportion of their assets to equities. In tandem, household financial assets tend to grow in line with gross domestic product (GDP). In spite of China’s economic growth rate declining, it is expected by many economists to remain strong, especially relative to developed economies. With GDP continuing to rise, a steady stream of new capital is likely to flow into onshore stock exchanges.

Next, looking at foreign investors, China’s restrictions on foreign participation in its domestic stockmarkets has meant that most either invested in the offshore market (mainly in Hong Kong) or applied for permission to invest in the domestic A-share market under the Qualified Foreign Institutional Investor (QFII) programme, with strict rules and lock-up periods.

However, the market liberalisation reforms will enable foreign investors to buy securities on the local Shanghai and Shenzhen exchanges, which in time should help make the market more liquid and less volatile.

The market capitalisation of the Shanghai and Shenzhen stock exchanges exceeds RMB50trn (£5.2trn) but still has a long way to grow. This is the key to the exciting long-term equity opportunity in China and provides a compelling argument in favour of a larger, long-term allocation to Chinese onshore equities.

As Beijing allows greater international participation in the local stock exchanges, foreign investors will have freer access to a far larger investment universe than the small number of Chinese firms listed offshore. As more overseas investors seek to enter this new market, Chinese shares are likely to become a more important part of global investors’ portfolios and encourage the leading index providers to include domestically listed A-shares in their global indices, which could create a virtuous cycle of foreign investment.

Taking advantage of this opportunity is challenging. Foreign investors own about 2 per cent of the equity listed on China’s domestic stock exchanges, in contrast to Taiwan and Japan, for example, where foreigners hold about a quarter and a third respectively. This investor dynamic results in substantial volatility, which might be unappealing to foreign institutions, but it should not be a reason for long-term investors to shy away from the opportunities presented by China’s economic rebalancing.

Finally, the structural change in the way investors allocate capital should also be buoyed by continued economic expansion. Although Chinese GDP growth has halved from more than 14 per cent annually in 2007 to approximately 7 per cent in 2015, it remains strong, especially compared to developed economies, where growth has been sluggish. As the economy grows, more domestic savers will have larger asset pools to invest in the stockmarket. This dynamic will feed steadily increasing domestic capital flows into the Chinese equity markets.

Those investors able to look beyond the headlines and focus on understanding the significant structural shifts taking place in China’s onshore stockmarkets will ultimately benefit from this historic moment. In the long term, the market is expected to become more mature and more liquid, making the case for a rising allocation to Chinese equities in global portfolios.

Greg Kuhnert is a portfolio manager in the Investec 4Factor equities team

EMERGING ASIA

Macro view

Stanley Fischer, vice chairman of the US Federal Reserve, discussed the transition phase for emerging Asia in a recent speech, ‘Policy Challenges in a Diverging Global Economy’, at the 2015 Asia Economic Policy Conference in San Francisco.

He stated: “As many have noted over the years, maintaining growth sufficiently rapid to meet the development aspirations of the region will require a transition toward an economic paradigm more rooted in domestic demand, particularly consumption.

“The need for this transition, or rebalancing, is most apparent and also widely acknowledged in China, the current hub of emerging Asia’s export-led model. The need for these economies – primarily China, but also those economies that export through China – to switch toward domestic demand largely reflects their having become too big and too important to rely to the extent they have on the export-led models of the past.

“On growth, the bottom line that should be emphasised is that even with a diminished pace of growth, the region is still expected to significantly outpace the global economy and make by far the largest contribution to global growth in the years ahead.”

Expert view

Matthew Sutherland, head of product management in Asia for Fidelity International:

“Asian countries learnt a big lesson in the Asian currency crisis of the late 1990s. They got their houses in order and kept them in order after that. So levels of foreign debt to GDP are low, foreign exchange reserves to GDP are high, and most of these countries have a current account surplus. Weakest on these measures is Malaysia, probably followed by Indonesia.

These points are central to the case we have been making for some time now, that Asian emerging markets should perform better than their non-Asian peers in a rising US interest rate environment. Commentators tend to generalise about ‘Gems’, but we think it is important to drill a bit deeper and take note of the differences.”