China - the crouching tiger, hidden dragon
The "crouching tiger, hidden dragon" is an idiom stemming from Chinese mythology reminding us not to underestimate people, especially when they may have "hidden strengths".
Last year, Chinese economic growth softened and the country unveiled a range of supportive fiscal and monetary measures, aiming to stimulate its economy. Six months into 2019, China is starting to show signs of recovery. Industrial production rebounding strongly in March and Q1 2019 real GDP growth beat market expectations. Solid macroeconomic data suggests policy measures are starting to bear fruit, leaving investors with the question: is the crouching tiger ready to pounce onto the world stage?
Index inclusion
As the world's second largest economy and accounting for one sixth of the world's GDP (1), China is too big for investors to ignore. Yet its onshore bond and equity markets have only just begun their integration into global capital markets.
From April 2019, Chinese government and high quality renminbi (RMB) bonds will be included into the Bloomberg Barclays Global Aggregate Index, which is estimated to have tracking assets of $2.5trn. On completion of the 20-month phased-in inclusion period in November 2020, onshore Chinese bonds will no longer be an off-benchmark option for index following investors, but will, by default, have a weighting of around 6.1%.
In addition, in March 2019, MSCI announced it would quadruple the weighting of China's A-shares in its emerging markets index, through a three-step implementation in May, August and November. In the short term, the weight increase could lead to upwards of $70bn in equity inflows into the A-share market in 2019. Over the medium to long term, better representation in global indices could have a more profound impact on the development of the Chinese capital markets.
Besides MSCI, other index providers such as FTSE Russell and S&P Dow Jones will also begin to include A-shares in their global benchmarks later this year, attracting more flows from passive funds and other benchmark-tracking portfolios.
Catalysts for the Chinese stock markets
Since the beginning of the year, the Shanghai Shenzhen CSI 300 Index (SHSZ300) has rebounded strongly, returning 20% YTD (as of 31 May 2019). Despite the strong performance, equity valuations continue to look attractive. The index is currently trading at forward price-earnings ratio of around 12x, below its 10-year average.
Valuations of China A shares look attractive relative to history
Source: Bloomberg, HSBC Global Asset Management, 31 May 2019
The announcement of the MSCI inclusion was an important milestone for Chinese equities, but it is hardly the only catalyst driving the rally. Chinese authorities are likely to continue to keep a close eye on economic activity, prepared to roll out supportive policies to buffer an economic slowdown. Earnings of Chinese companies should also be expected to slowly pick up as the impact of the government's stimulus measures starts to feed through to corporate profitability.
Chinese fixed income
Within fixed income, both onshore and offshore RMB denominated bonds have performed strongly since the start of this year, rising 1.0% and 2.8% respectively in local currency terms (as of 31 May 2019).
Benign inflation, concerns over RMB depreciation subsiding, accommodating monetary policy and the People's Bank of China's preference to lower lending rates, should all be supportive for the RMB bond market. In addition, RMB bonds offer more attractive yields when compared to their developed market counterparts, such as Germany and the US. To illustrate, China's five-year government bond yields are currently trading at about 117 bps higher than the US and 366 bps higher than Germany.
China vs US vs German government bond yields
Source: Bloomberg, 31 May 2019
On the currency front, China has reiterated its desire to maintain a stable exchange rate, which is of paramount importance to foreign investors. In a recent interview, Liu Guoqiang, deputy governor of the People's Bank of China, reassured investors that China had ample policy tools to manage exchange rate fluctuations, and its sound economic fundamentals would continue to support the currency.
Under the government's supportive policy stance, we expect China's economy to continue to improve, which should result in improving earnings growth and healthier balance sheets for corporates. Over time, as the internationalisation of Chinese capital market gains traction, liquidity inflows and strong underlying fundamentals should help in the rerating of the A-shares and Chinese bond markets from their current undemanding valuations. A well-balanced portfolio including both asset classes should provide investors with a good exposure to capture the promising growth potential of China.
Source: (1) "World Economic Outlook Database", International Monetary Fund, 10 April 2019; (2) "China Review (April 2019)", HSBC, 10 April 2019
Stephanie Hak is a product specialist, Multi Asset Products at HSBC Global Asset Management
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