RISCURA: Expert Opinions: Edition June / August 2020




By Lars Hagenbuch, consultant at RisCura

Each day now brings further news of the spreading coronavirus and its impact on communities and economies, but some positives have started to emerge, most notably from China. Chinese equity indices have recently outperformed global markets significantly. In addition, Chinese investment managers have continued to outperform during these turbulent markets. In short, China has offered material diversification benefits recently just as it did from 2007 to 2009. The low correlation of Chinese equities with other regions is well-documented. But, why is this? In our opinion, a fundamental reason is the unique shareholder base that has different motivations to shareholders in other countries, both in developed and emerging markets.

We believe foreign shareholding will increase over time. However, it depends on many factors such as the pace of reform of Chinese markets, and adoption by global asset owners, index providers and fund managers.

For now, Chinese A-shares are not reliant on the same global flows as other equity markets. There is an almost consistently high, positive relationship between developed markets and emerging markets whereas the relationship between Chinese A-shares and developed or emerging markets is inconsistent and negative at times.

Furthermore, the make-up of Chinese shareholders is very different. Almost half are retail investors. Many, if not most, local asset managers are still guided by short-term performance. This means that prices are driven far more by sentiment and speculation than underlying fundamentals of companies. This creates a different pattern of returns, albeit with higher volatility.

Next, the Chinese state attempts to manage all aspects of the local economy. We recognise this as a double-edged sword: centralised management means that the country can achieve objectives that are nearly impossible for others – for example, around infrastructure or regulatory changes – but policy mistakes do happen and can be costly. The management of financial markets is no exception. Just as many of the world’s investment policies are shaped by the US Federal Reserve and European Central Bank, the Chinese are affected by what their central bank does. Over the last decade, China has implemented both extremely tight and loose monetary and fiscal policies in pursuit of a stable economy. This has caused shorter and sharper market cycles that can be completely unrelated to what is happening elsewhere in the world. Unconventional measures may also be used, like influencing the activities of state-owned asset managers to prop up stock markets. When mistakes are made, having ‘executive control’ allows the Chinese government to respond to policy mistakes quickly.

The last pillar, perhaps most important in the longer run, is the Chinese economy, fed by its large population. There are more than 5 000 Chinese companies listed on the mainland and internationally that benefit from this large population, which is well-connected through technology and roads and railways, with a fast-growing middle class, a steady trend towards urbanisation and with that substantial domestic consumption. Many of those 5 000 companies only focus on domestic business and have little exposure to overseas markets. The vast domestic market presents them with incredible growth opportunities. All this means that China can press ahead independently and impact the world in a way that currently only the US can.

Every investor seeks diversification and we believe that China has much to offer to improve the risk profile of an equity portfolio. Ignoring it, or lumping it in with the emerging markets allocation, leaves a tasty free lunch uneaten at the table.