Two years ago, Chinese stock markets sent tremors around the globe. Share prices tumbled as traders fretted about the growth prospects of world’s second-largest economy.
The rout soon spread across US and European markets, causing such mayhem that Apple’s stock momentarily plunged 13 per cent. About half of the stocks listed on the Chinese market were temporarily suspended from trading.
Today, China’s fortunes have improved dramatically in the eyes of international investors. Chinese equity funds have been the best-performing asset class for UK investors in the year-to-date, and plenty of emerging market and global equity managers are excited about the market’s long-term growth prospects.
“Basically we’ve gone from alarms and blue lights flashing that China is about to crash, to thinking it’s pretty much steady as she goes,” says Gary Greenberg, head of global emerging markets at Hermes, the asset manager.
That is not to say that all fund managers are rushing back in. According to research by Goldman Sachs, global and emerging market fund managers are still underweight in China against their broader indices — although they have been gradually increasing their exposure over the year.
Goldman says Asian markets are up 25 per cent since the start of 2017 — their best performance since the post-financial crisis recovery in 2009. Funds investing in China returned nearly 19 per cent to investors on average over the six months to June 30, according to separate data from Morningstar.
It all sounds like good news for investors — but have the blue flashing lights really gone away? FT Money examines the long-term case for investing in China, the likely risks and rewards, and the best ways into this fast-changing market.
For all the country’s recent good performance, investors still have plenty of concerns about China’s economy. Rather than a roaring dragon, James Kynge, the FT’s emerging markets editor, likens it to a “Chicken Licken economy”.
“What investors are worried about is whether the sky is going to fall in,” he says. “Two years ago a lot of them thought it would. Now, very few of them do.”
In 2016, China grew at its slowest pace since 1990, as its manufacturing and construction industries slowed and fears abounded about its debt levels.
According to the Bank of International Settlements, China’s total debt has grown from $6tn at the end of the financial crisis to almost $28tn at the end of 2016. This means its total debt is equivalent to 260 per cent of its GDP, while the debts of Chinese companies are about 170 per cent of GDP.
Standard & Poor’s, the credit rating agency, downgraded the country’s sovereign debt by one notch this week, following a similar move by Moody’s in May.
In August, the International Monetary Fund warned that the Chinese government was not doing enough to rein in the country’s “dangerous” debt levels, which it said would make it more difficult for policymakers to react to a potential “loss of confidence” in asset and wealth management products.
The products, which have underpinned the expansion of China’s shadow banking sector, are generally sold to Chinese retail investors by its banks — but investors have been buying under the illusion that the banks are guaranteeing their returns.
Julian Evans-Pritchard, China economist at consultancy Capital Economics, says banks have been willing to stand behind these products so far because selling them has proven so lucrative. However, the size of the exposure could prove costly.
He warns that if the banks’ implicit guarantee unravels, households might rush into withdrawing funds. This would force down revenues at Chinese asset managers and cause problems for smaller banks which rely on asset managers as a funding source.
Concerns about high debt levels and the shadow finance sector have caused some fund managers to steer clear of China altogether. Others point to recent efforts by local regulators to tighten financial conditions. In July, China’s central bank — the People’s Bank of China — announced it would do more to regulate the sale of investments by banks.
“We are structurally worried about the level of debt, of course,” says Nadège Dufossé, head of asset allocation at French fund manager Candriam. “But the Chinese government is tightening financial conditions — it is trying to manage the risk, so for the time being, I’m less worried.”
Karine Hirn, chief executive officer at fund house East Capital Asia, agrees: “The regulator has shown it wants to do something about it, and is tackling the most problematic parts of the sector.”
The Wild East
The Chinese government has shown it is willing to intervene in markets when it feels it is necessary — but this can be bad news where investors are concerned.
This year, China’s foreign exchange reserves fell to below $3tn as ambitious companies made a series of large overseas acquisitions. This prompted a crackdown from Beijing, which has accused some of its larger companies of posing “systemic risk” — which, in turn, resulted in the high-profile detention of Chinese businessman Wu Xiaohui, the head of insurance group Anbang.
Mr Greenberg of Hermes says he thinks about Chinese companies’ “social licence to operate” when looking at whether to invest. “They are very aware of it,” he says. “You play the game and you fund a school and a reservoir, and you are a good citizen. The amount of work Alibaba has done in its home city [Hangzhou] is phenomenal,” he adds. Conversely, says Mr Greenberg, companies that take “lots of money” out of the country soon learn the consequences. “In China, nobody will let you get away with that.”
Corporate governance is another issue. Chinese companies are not subject to the same accounting and legal rules as those in Europe or the US. Broadly, though, fund managers argue that companies in emerging markets will always run the risk of having weaker corporate governance structures than those in developed markets.
“Admittedly, corporate governance standards overall are not up to developed market standards,” says Jennifer Wu, fund manager at JPMorgan. “I’d say we are pragmatic in how we incorporate governance views and considerations — we won’t purely exclude if there are governance issues, but we work with management to see how they could do things differently.”
Is there a risk that the chief executive of a Chinese company you have invested in will disappear? “Yes,” says Mr Greenberg. “It’s a risk that the corporate chiefs get too big for their breeches. The requirement in China is that you stay out of politics and you co-operate.”
Despite these potential problems, Chinese markets are becoming increasingly open to overseas investors. While several major Chinese companies are listed in Hong-Kong or New York and already available to overseas investors, those listed in mainland China are much harder to access.
This summer, MSCI, the emerging markets index provider, decided it would include mainland Chinese shares denominated in renminbi — so-called A-shares — in its global and emerging market indices for the first time from next year.
This will automatically funnel more of the world’s wealth into China’s stock markets — every passive fund tracking an MSCI index featuring Chinese shares will be duty bound to buy them from next year. It is estimated that about $1.6tn of assets in funds globally follow MSCI’s emerging markets index.
Many brokers and investors say this heralds an enormous victory for globalisation and cross-border investment. “This is the start of internationalisation,” says Ms Hirn, of asset manager East Capital. “Everyone is excited for good reason.”
Ms Hirn says the inclusion of A-shares has already brought new interest from overseas investors — even though the portion of the Chinese stock market that will be included is very small. “You cannot ignore this market any more,” she says. “My colleague is just back from Shenzhen and he said he wasn’t the only foreigner any more.”
Others are less excited, and point out that even MSCI is being cautious. To begin with, only about 5 per cent of the weight of each Chinese company’s full market value will be included in the index, and only 222 large-cap companies will be eligible.
This has left some investors shrugging their shoulders. “Really, it’s not going to make a huge difference to flows and valuations of A-shares, given the percentage inclusion in the index we’re talking about,” says Patrick Thomas, investment manager at Canaccord Genuity Wealth Management. “There’s a lot of hype about it, but it’s less than 1 per cent of the index.”
MSCI has argued that including Chinese stocks in its indices will help the country bring its markets into line with western standards. “Future inclusion will be subject to a greater alignment of China with international accessibility and trading standards,” Sebastien Lieblich, MSCI’s global head of index management research, told the FT in June.
A troublesome financial system and slowing growth mean investors in China have to be watchful. “Everyone agrees China is the biggest story for the global economy — but it’s not an easy story for your investments,” says Markus Stadlmann, chief investment officer of Lloyds Private Bank, the bank’s wealth management arm.
The Chinese government wants to move the economy towards one powered by home consumers, referred to by fund managers as the “new China”. It is here, investors say, that the best investment prospects can be found.
“Investors tend to focus too much on macro concerns, which prevents them from looking at the companies that are doing well,” says Jian Shi Cortesi, Asian equities portfolio manager at Swiss fund house GAM.
Ms Cortesi points to two high-growth technology companies whose names are familiar around the world — Alibaba (think China’s answer to Amazon — only much bigger) and Tencent, the internet giant whose app-driven business spans social media, gaming and e-commerce.
Tencent and Alibaba — listed in Hong Kong and New York respectively — are the largest and third-largest constituents of MSCI’s emerging markets index. Ms Cortesi says that among China’s mainland listed shares, there are more companies with their potential.
“Alibaba and Tencent both started in the late 1990s or early 2000s, and over the past 10 years they’ve grown into billion-dollar companies,” Ms Cortesi says. “My job is to find these attractive companies.”
Technology stocks are part of what Ms Cortesi sees as the unfolding consumer story in China. Since 2013, she has avoided holding manufacturing stocks in her portfolios and has focused more on what ordinary Chinese people are buying.
“We look at where people spend their salaries,” she says, noting the desire to spend more on experiences. “People are eating better quality food and drinking more expensive beverages, and people are spending more on intangible things like travel and education.”
Growth stocks focused on these areas are what fund managers are looking for — and what they are not finding in the manufacturing and construction sectors that used to dominate the Chinese markets. “The growth is more stable for the new economy [shares],” says Ms Dufossé of Candriam.
Even investors who dislike other parts of China’s ecosystem love their tech and internet companies.
“Although people love to hate China, they love to love internet stocks in China,” says Josh Crabb, head of Asian equities at Old Mutual. “Investors are often very inconsistent,” he says, pointing out that it doesn’t make sense to buy China’s technology companies “if you think the banking system is going to implode”.
The four largest Chinese “internet” stocks — Baidu, Alibaba, Tencent and JD.com — are already popular across global equity funds, which has led to some fund managers worrying about excessive valuations — just as they do with the US technology “Fang” stocks of Facebook, Apple, Netflix and Google.
“Comments have been made by a number of fund managers recently [around] the sheer valuation levels of these companies,” says Patrick Thomas, investment manager at Canaccord Genuity Wealth Management. “If people think Apple and Netflix, et cetera are expensive, the same is definitely true of Alibaba and Tencent.”
Cyrique Bourbon, portfolio manager at Morningstar, says whichever way you view it, China is to be viewed as a “high-risk opportunity”, partly because of corporate governance issues and a lack of transparency.
But the upside for risk-taking investors is potentially large, says Mr Greenberg of Hermes. In an inefficient market, careful stockpickers could win big. As the country’s market opens its doors to overseas investors, today’s unheard-of stocks could turn into tomorrow’s multinationals.
Gaining exposure to China
If you are going to make the leap and allocate some of your portfolio to China, you need not buy a specialist China fund — though this might give you access to some of the smaller companies and sectors in the country. Plenty of Asia ex-Japan, emerging market, or even global equity funds allocate a portion of their capital to China.
“There’s a huge opportunity here for active management,” says Mr Stadlmann of Lloyds. “The best opportunities are there for global and emerging markets equities funds, because they have the entire playing field, and can invest in companies benefiting from Chinese growth sector by sector, but also they can invest in China if they want.”
Over three and five years, the best-performing specialist China equity funds for sterling investors have all been active funds, according to figures from data provider Morningstar. These funds hold a mixture of A-shares, shares in Chinese companies listed in Hong Kong or the US, and shares listed in mainland China but trading in overseas currencies.
For retail investors, the top performing sterling-denominated funds over a three-year period have been GAM’s China Evolution, Fidelity China Focus and Henderson China Opportunities — which have returned between 77 per cent and 83 per cent over that time.
GAM’s fund holds Tencent and Alibaba as its largest constituents, and its biggest sector weighting is information technology. It also has a large tilt towards consumer discretionary stocks (more than a fifth of the fund is dedicated to them), and an ongoing charge figure (OCF) of 1.05 per cent.
Henderson’s fund invests about two-thirds of its assets in Hong Kong listed Chinese companies, with only around a tenth of the fund buying A-shares. The largest holdings are Alibaba and Tencent, which make up about a fifth of the fund, and its OCF is 1.72 per cent.
Fidelity’s China Focus, run by manager Jing Ning, takes a slightly different approach. While technology and consumer cyclicals are among its top three sector weightings, it also devotes around a third of its assets to financial services. The fund has an OCF of 1.91 per cent.
Alongside its China Focus fund, Fidelity also offers the only specialist China-focused investment trust, Fidelity China Special Situations. Formerly run by star manager Anthony Bolton, the fund hit trouble soon after its launch in 2010 when the Chinese market slumped. Unlike open-ended funds, investment trusts can use gearing to boost returns — although this can also potentially magnify losses, as it did during Mr Bolton’s early stewardship.
The manager managed to turn the fund around — when he stepped down in 2014 the trust had beaten the wider Chinese stock market, but was only trading slightly above launch value. During his last day in the office, Mr Bolton admitted he had been “wrong about the market in China”.
Now run by Dale Nicholls, the fund has achieved a share price total return of 84.3 per cent over the past three years, and its gearing is currently 25 per cent of assets. About 40 per cent of its assets are in consumer discretionary stocks, and a further 35 per cent in information technology. Up to 10 per cent of its assets can be invested in unlisted companies — among its 20 largest holdings is Xiaoju Kuaizhi, an unlisted taxi booking app which operates across 400 cities in China. The trust’s OCF is 1.15 per cent.