Structurally, these are historic times

This article is part of
Investing in Asia - November 2015

There is little doubt that China is going to play a major role in determining the trajectory of global markets.

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.

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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.