There are many valid reasons investors are underweight China equities relative to its world footprint. This includes an unfavorable reputation, trade conflicts, regulations, investor access, accounting and governance, national security risk, and its classification as a developing country. However, there are compelling, positive attributes that more than offset these: 1) a rising and formidable world power, 2) growth opportunities, 3) improving regulatory conditions, 4) market performance and diversification benefits, 5) favorable valuations, 6) rising institutional ownership, and 7) attractive market return potential. Risks are real, but there are catalysts for worldwide investors to boost their positions in China equities, fueling strong performance.
Investors are Underweight China Equities
China’s GDP in 2019 was $14.14 trillion compared to $21 trillion for the U.S. On an equal purchasing power basis, China’s $27 trillion GDP is now greater than that of the U.S. China GDP was up by 4.9% in the third quarter of 2020. The governor of the Peoples Bank of China estimates 2020 growth at about 2%, despite the pandemic. It is expected to be the only major country that will experience growth this year.
China’s stock market cap just reached a record high of $10 trillion. This trails the U.S. market cap of approximately $36 trillion. While the U.S. accounts for just 24% of the world’s estimated $88 trillion GDP, it has 41% of the world’s estimated $85 trillion market cap. Conversely China has 16% of world GDP, but only 12% of world market cap. China’s GDP growth has run at about 8% per year for the past ten years compared to the U.S. at about 2.5%.
U.S. investors have an estimated 5% of their equity portfolios allocated to emerging markets, which translates to only about 2% of their equities in Chinese stocks. (This is based on the 41% allocation to China in the MSCI Emerging Markets Index). By comparison, U.S. investors carry a weight of approximately 79% of total equities in U.S. stocks. Based on China’s economic footprint and sustained growth, it would seem a U.S. investor allocation more like 10-20% in China, or five to ten times higher, would be expected.
So why are investors underweight China? There are good reasons.
One can argue it is un-American to invest in China. If you feel strongly ideologically that this is enough to stay away, then read no further. However, if you want to make a purely financial decision, please read on for the facts and associated opportunity we are presented with today.
A recent Pew survey indicated a record 73% of Americans had an unfavorable opinion of China, 73% believe the United States should promote human rights in China, and 50% believed the US should “hold China responsible” for the role it played in COVID-19.
There are also ESG concerns. For example, the iShares MSCI China A ETF (CNYA), consisting of 475 companies in the Chinese A-Share market, sports an ESG score of 1.5 out of 10 and a B rating – second lowest on the scale.
For the past several years, the Trump administration has taken on China for its trade and intellectual property rights practices, somewhat dimming its growth prospects. The outcome of this is highly uncertain, but the data so far show that sanctions have done little to curtail China’s overall growth and rectify the trade imbalances. The effects of the pandemic have overshadowed trade measures and both countries seem destined to shift their economies towards more independence.
A Trump win would mean more of the same, while experts believe Biden would likely maintain the Trump tariffs and pursue a more multilateral approach by working with allies. Biden has said he would not be in a rush to reenter the Trans-Pacific Partnership that Trump exited.
Regulations and Access
Up until recent years, the Chinese government has imposed regulations that made it hard for investors to buy shares and has limited capital flows from foreigners into their markets. Despite easing capital controls allowing a limited number of foreign investors to trade on the Shanghai and Shenzhen exchanges, only 5.4% of shares are foreign-owned, according to Investopedia.
China A Shares are listed on either the Shanghai or Shenzhen stock exchanges and are traded in renminbi (CNY). B Shares are listed on the Shanghai stock exchange and are traded in U.S. dollars (USD), or they are listed on the Shenzhen stock exchange and traded in Hong Kong dollars (HKD). H Shares are listed on the Hong Kong exchange and are traded in Hong Kong dollars (HKD).
U.S. investors have always been permitted to purchase and sell B Shares and H Shares, but A Shares were limited to mainland Chinese investors until the launching of the Qualified Foreign Institutional Investor (QFII) program in 2002. Controls on A Shares have been periodically relaxed since the launch of QFII, including the 2014 introduction of the Stock Connect and the Bond Connect trading programs that permit two-way trading between Hong Kong and China.
Accounting and Governance Standards
“As more China-based companies have listed in the U.S., there has been growing concern about the lack of transparency into accounting and governance standards of Chinese firms,” according to an SEC document published in July. The SEC also cites concerns with fraud and other misconduct among Chinese firms.
The United States’ Holding Foreign Companies Accountable Act prohibits securities of a company from being listed on any U.S. exchanges if it has failed to comply with the Public Company Accounting Oversight Board’s audits for three years in a row. The measure could affect any firm, but could particularly affect state-owned Chinese firms. By one estimate, as many 200 Chinese companies could be delisted. The Act was passed by the Senate in May, but hasn’t been approved by the House yet. This could be due to potential drawbacks. For example, Chinese issuers are likely to go elsewhere, China may accelerate state-backed investment for its own companies to the disadvantage of U.S. firms, and China could retaliate against U.S. multi-national companies.
The Obama administration originally allowed Chinese firms exemption from auditing and the bill has been sitting in the House under Pelosi for months now. This makes you wonder if there is a political resolve to pass it – particularly if Biden wins. “We believe that a rising China is a positive development,” said then Vice President Biden when giving a speech in Chengdu, China.
Curiously, I couldn’t find any reports less than 30 days old regarding the status of the House deliberations. It appears there are more important matters, like the election, on their minds. Or perhaps they want to stall until after the election, hoping for a Biden win.
Representation in Equity Indexes
Although it’s the world’s second-largest economy, China is still classified as a developing nation and is prominently featured in all emerging market indexes. For example, the MSCI Emerging Markets Index carries a weight of 41% in China. While this is a hefty allocation, it needs to be viewed in context of investors’ overall low exposure to emerging markets equities as cited above. Another gauge, the FTSE Russell All-World index of large and mid-cap stocks, weights the U.S. at 57% of the total and China only 5%. This further suppresses indexers’ and large institutions’ exposure to China.
National Security Risks
The SEC states:
The increasing exposures of U.S. investors to Chinese financial markets that are intertwined with the Chinese government’s political agenda has raised national security questions for the U.S. For example, certain domestic Chinese companies are included in global financial market indexes, despite being directly involved in activities contrary to U.S. interests.”
As a result, the U.S. government has banned some Chinese companies from doing business with U.S. individuals and companies. A prominent example is Huawei, the leading smartphone maker, which was restricted from doing commerce with U.S. companies due to alleged previous willful violations of U.S. sanctions against Iran.
Government Ownership in Equities
Many Chinese companies are state-owned, creating misalignments with shareholder interests. McKinsey notes that Return on Assets is lower for state-owned enterprises. Fifty-seven percent of China’s national debt is corporate debt, with about 70% of that carried by state-owned enterprises.
Reasons to Invest in China
If you’ve read this far, you are open minded and/or curious about the investing opportunity in China. Below, I cite seven key reasons to consider a higher weighting in your portfolio.
A Rising World Power
This topic could take up many articles all by itself. Since many articles already exist, I will point you to my favorite: the excellent The Changing World Order series written by Bridgewater’s Co-Chairman and Co-Chief Investment Officer, Ray Dalio. The chart below is a snippet from his series showing how major world powers have evolved over several centuries.
Source: Ray Dalio, The Changing World Order LinkedIn series.
China (the sharply rising red line) is approaching parity with the United States, whose line is in descent. One could certainly argue this is a subjective assessment. Yet, Dalio considers eight measurable factors including: 1) education, 2) competitiveness, 3) technology, 4) economic output, 5) share of world trade, 6) military strength, 7) financial center strength, and 8) reserve currency.
Not taking his word for it, I conducted my own research. The table below depicts various objective measures that I found from reliable sources. If you’d like more depth, last year McKinsey wrote an impressive and comprehensive research report, China and the World.
Sources: Investopedia.com, Macrotrends.net, Nature.com, AIP.org, McKinsey.com, Statistica.com, TheBalance.com, globalfirepower.com, Wikipedia.com
You can see that the data corroborate Dalio’s chart. China is very strong in education, competitiveness, technology, economic output, share of world trade, and military strength factors. The U.S. has the privilege of the world’s reserve currency. But as Dalio’s series and I have described in Why the Smart Money Will Ignore the Election and Pay Attention to This, that might not last much longer. The pandemic and associated stimulus programs are severely testing the limits of our currency’s resilience.
Besides having strong and consistent GDP growth, China is the home to many world powerhouses. It has 120 of the global Fortune 500 companies. This includes many tech giants including Alibaba (NYSE:BABA), Tencent (OTCPK:TCEHY), Xiaomi, JD.com (NASDAQ:JD), Baidu (NASDAQ:BIDU) and the controversial Huawei. According to VC firm Kleiner Perkins, China is home to nine of the world’s top 20 tech firms. There were 37,800 active Chinese software companies as of the end of 2018. China is also pushing hard to become the world’s Artificial Intelligence (AI) leader and according to some experts is now close to the U.S. in terms of overall capabilities.
Source: IBIS World, 2020
Improving Regulatory Conditions
This could be a key catalyst in fueling Chinese equity performance going forward. McKinsey also discusses how China is steadily improving conditions for investment:
We note that China has gradually been improving the regulatory environment for inward investment. …The number of specified restrictions fell from 139 in 2014 to 48 in the 2018 revision. Furthermore, the negative list details plans to open up certain sectors in some respects. For instance, joint venture requirements in the financial services sector will be removed by 2021. Moreover, China has launched 12 free trade zones in the past five years, and there have been calls to make these zones less restrictive to foreign investors.”
McKinsey cites the steady downward trend in Foreign Direct Investment (FDI) restrictiveness since 2003. This obviously bodes well for investors, especially large institutions, to increase their exposure to China.
Market Performance and Diversification
The chart below shows the performance of China (Shanghai index) and other major equity markets this year. It is interesting that although China was the epicenter of COVID, China stocks have outperformed all the other major country indices this year. During the panic selling in the spring, the Shanghai dropped about 10% while U.S. and other equity markets experienced declines on the order of 35%. Yet the Hang Seng, which includes the largest companies trading on the Hong Kong exchange, is down 12% YTD.
Source: Advisor Perspectives, World Markets Update
On a longer term basis, since 2000, the Shanghai index of mainland China has also performed well, about equal to the U.S. The Hang Seng hasn’t fared as well – up only 42%.
Source: Advisor Perspectives, World Markets Update
However, since the market bottom in March 2009, the Shanghai index has been a laggard, gaining only 58%. The Hang Seng was up 117%.
Source: Advisor Perspectives, World Markets Update
The correlation between China equities and U.S. equities was running at about 0.05 as recently as 2018, before rising to a high of 0.40 during the onset of the pandemic in March. Bridgewater research shows current China equity correlations running at 0.5 relative to a U.S. traditional portfolio. This level still offers attractive diversification benefits for U.S. investors. Looking ahead, trade and political tensions will likely foster continued movement toward greater independence of the countries’ economies which is likely to reduce correlations.
Currency diversification is another benefit of Chinese equities and one that could be very significant. As I’ve mentioned, many factors point to a weaker dollar. Dalio discusses this at length in his article series and it’s another reason Bridgewater holds significant positions in China equities and bonds. While I wouldn’t expect the renminbi to ascend to reserve currency status any time soon, the continued U.S. debasement of the dollar argues for currency diversification, with China being a good vehicle.
Based on the Buffett Indicator (market cap to GDP) China equity market valuations are cheap compared to those in the U.S. China’s ratio at 67% is less than half that of the U.S. at 172%. The latter eclipses the Y2K bubble peak of 159%. (Note the FRED data series depicted in the chart below ends in 2017). Then again, China valuations have trailed those of the U.S. according to this metric for the past 20 years. This can easily be explained by the reasons discussed above.
Yet, China market cap reached about 80% of GDP in 2007, following a steady rise from a mere 10% in 1996. Since the 2008 financial crisis, the ratio has fluctuated around 50-60%. During that time, the U.S. became much more expensive, nearly doubling from 93% in 2009 to today’s 172%. Will the gap in China’s market cap to GDP narrow? It depends on several factors, perhaps most importantly, investor sentiment. Continued economic growth, favorable changes in regulation, geopolitical developments, company profitability and trade policies will certainly matter.
If the market simply maintains its level at around 60% of GDP and annual growth can return to the pre-pandemic 6% pace, investors could see annual returns comparable to that. Certainly not a blockbuster, but not bad, especially with the diversification benefits noted above. Moreover, if valuations adjust back towards the 80% of GDP level or higher, investors could easily get a 33% kicker (20% point rise divided by 60%) on top of the GDP growth-fueled increases.
China P/E ratios also look reasonable right now (as represented by CNYA) at 19 times trailing pandemic-depressed earnings. All in all, current valuations provide a factor of safety with nice upside potential.
Rising Institutional Ownership
According to Investopedia, “While the proportion of U.S. equities managed by institutional investors stood at 62% in 2019, 99.6% of total investors in China’s stock markets were retail investors.” That presents an enormous upside for institutional share ownership. Appropriately, more than half (52%) of institutional investors surveyed in a recent Barron’s Big Money poll indicated they plan to add to equity positions in China over the next six months.
In 2019, MSCI increased the inclusion ratio of China A shares from 5% to 20% in the MSCI Emerging Markets Index. MSCI’s website states, “Investors globally are now increasingly re-evaluating the appropriate allocation framework of their equity portfolios. China’s growing economic strength and improving market accessibility may transform the characteristics of the emerging-market asset class and its role in global portfolios.”
Perhaps the most prominent proponent of investing in China is Dalio’s Bridgewater, whose research paper states:
While there are many risks to investing in Chinese assets, we think the expected returns relative to the risk of Chinese assets are attractive.”
In summary, continued relaxation of China regulations, better access to capital markets and increasing size of the economy and equity markets all serve as catalysts for increased institutional ownership.
China Market Return Potential
To recap, there is a potential 33% upside from the Buffett indicator revaluation. The Bridgewater paper cites the 10-year expected annual return for China equities at 8% vs. only 3% for U.S. equities. Another potential return kicker could come from a shift in investor allocations. For example, let’s say the world shifted its market cap allocations to China (presently 12%) to match the country’s world GDP contribution of 16%. That represents a shift of 4% of world market cap of $85 trillion, or $3.4 trillion into Chinese stocks. That’s a 34% increase in the value of Chinese stocks. You wouldn’t expect that to occur quickly. But the combination of these potential accelerators coupled with continued economic growth and an increasingly favorable regulatory environment can add up to nice returns over a five- to ten-year investing horizon.
In summary, there are risks and rewards from inclusion of China equities in a portfolio. This analysis suggests that investors have unduly underweighted their portfolios and the rewards outweigh the risks. For those investors who are ok with the ideological drawbacks of China investing, I believe a weighting in China equities of 10-15% of a portfolio’s equity component is reasonable. More aggressive investors can easily justify a higher allocation in hopes of capturing significant upside potential.
Implementation Ideas for Indexers
I think liquidity, size, issuing institution and longevity are important, so I begin my shopping list of potential funds with these. I plan to provide a full analysis of China equity index ETFs, including my top pick, in my next article. If you are interested in seeing that, please click the “Follow” button above to be notified when it is published.
Investors are underweight China equities. While there are good reasons, the degree of underinvestment appears to be overdone. China’s leadership is smart enough to understand that improvements in capital market access, regulatory policies, disclosure and other factors are needed to serve their self-interests. Indeed, the leadership has slowly but steadily been moving in that direction.
These factors along with rapid growth and the sheer size of China’s economy and equity markets serve as catalysts for worldwide investors to ramp up their equity exposure. Valuations and diversification benefits can add more lift. All this adds up to enormous upside potential with muted downside risk. As a result, investors should consider at least a weighting close to China’s share of world GDP – if not more – in their portfolios.
I look forward to your comments. If you found this article useful, please consider liking it, following me and forwarding it to a friend.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.