China s onshore equity markets

Transcription

1 INVESTMENT ACTIONS PORTFOLIO DESIGN RISK MANAGEMENT REGULATORY MARKETS China s onshore equity markets The next big thing in emerging markets FOR INSTITUTIONAL, PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY

2 Summary Jeff Shen Head of Emerging Markets and Co-Head of Scientific Active Equities In recent years, equity markets in China have lagged behind the spectacular growth of the economy. Various structural constraints made onshore equity markets relatively inefficient, while investment-led growth left little cash to distribute to shareholders. Now, with the government pushing to liberalize the economy and shift to consumption-led growth, equity markets may be entering a new phase. Rui Zhao Portfolio Manager, China Opportunities Fund Gerardo Rodriguez Portfolio Manager, Emerging Markets Gerald Garvey Head of Long Horizon Research Contents Financial liberalization and index inclusion may improve the sophistication and efficiency of Chinese equity markets, potentially making them a more attractive investment proposition for global investors. Reform efforts face significant hurdles, however, including the excessive growth of leverage and a credibility deficit after meddling with equity markets and mismanaging exchange rate policy in recent years. Even considering its challenges, we believe China has several structural advantages that may continue to support above-average growth over the medium term. A better functioning onshore equity market may benefit significantly in the coming years from the relatively fast pace of economic activity. Chinese equity markets, still broadly untapped by global investors, may become more attractive because of these trends. Introduction...3 Economic rebalancing...4 Macroeconomic challenges...6 Reform agenda and investment opportunity CHINA S ONSHORE EQUITY MARKETS

3 Introduction Over the years, academics and practitioners have documented the relationship between economic growth and equity market returns. 1 The logical argument says that when a country prospers, its equity market should do relatively well, too. Although a higher gross domestic product (GDP) per capita does not necessarily lead to higher equity returns, there is strong evidence that economic growth is good for equity markets (see chart below). The correlation of GDP growth with equity market returns has been historically around.5. Not always in lockstep Equity returns and GDP growth, % China This correlation makes intuitive sense. Over long periods, the growth of an equity market is often determined by the earnings growth of the companies listed on the market. Their earnings growth, in turn, is usually closely connected with GDP growth. However, that transmission mechanism has been far from perfect, and for shorter horizons it has been much weaker. There are also cases in which economic growth and corporate earnings outstrip stock returns over reasonably long time horizons. Particularly striking is the case of China, where the economy may have experienced the greatest growth in history over the past 2 years, but the equity market was little changed, notwithstanding a significant expansion in corporate earnings (see the chart below). 8 The China discrepancy Equities vs. corporate earnings and GDP IND 9 9 USD MSCI Annual Ex-China GDP growth Index Equity index RUS ZAR GDP COL Earnings Index level: 2 =1 6 3 Earnings GDP Equity index 2 2 UK 24 US BRA CAN MX Sources: Haver, CEIC and Bloomberg, December 216. Notes: The chart displays the Shanghai Stock Exchange A-share Index 6-month moving average, China GDP growth and China corporate earnings growth, all normalized to 1 beginning in year % Annual equity returns Source: Bloomberg, IMF, December 216. Equity returns are represented by the MSCI equity index for each country. 1 See Dimson, Marsh and Staunton 22, Triumph of the Optimists. THE NEXT BIG THING IN EMERGING MARKETS 3

4 China s path to prosperity is getting more challenging, especially given the excessive amount of leverage in the economy, as we explained in the BlackRock Investment Institute s recent publication China s Tricky Transition. Moving toward a market-based economy is never easy and it will take many years to reduce the prominence of state-owned enterprises. China will also have to restrain the government impetus to interfere in financial markets and deal successfully with excessive debt burdens accumulated in recent years. Notwithstanding these challenges, we believe China will continue to show above-average economic growth over the medium term, and may also start delivering strong stock market performance. We expect performance to be driven by financial market integration and the ongoing economic rebalancing in favor of domestic consumption, which are occurring after a long period in which Chinese equity valuations have been converging down to the levels of other emerging markets. Economic rebalancing It is no secret that the Chinese economy and its growth have become dominant factors in the global economy. In a sense, China is regaining the global prominence it enjoyed before the industrial revolution. During that period, the world was predominantly poor and the most important economies were those with the largest populations. With prosperity becoming widespread globally, we are going back to the future (see chart below). The rapid pace of Chinese economic activity has become particularly striking in a period of low global growth. China is now the most important contributor to global economic activity, and accounts for nearly a third of total global economic growth, according to 217 IMF data. More importantly, the composition of this growth is shifting away from investment toward consumption. This trend, which started in 21, is part of the policy framework for the future that authorities have laid out. The objective is to put the Chinese economy on a more sustainable medium-term path. The economic shift from investment to consumption will be crucial for China s stock market performance going forward. In financial statement terms, an investment-led boom implies that profit growth is disproportionally driven by the growth of corporate balance sheets. Back to the future Global GDP composition by country, 1AD-214 1% World GDP Composition Others France UK Italy Germany China Mexico Brazil U.S. 1AD Sources: The Maddison-Project, IMF, December CHINA S ONSHORE EQUITY MARKETS

5 We have known for years that this situation, characterized by divergence between earnings and free cash flow, is not necessarily a good thing for equity market returns. But as consumption becomes a more important component of overall growth, earnings quality tends to improve. Just like in other advanced economies, this can lead to a larger generation of free cash flow by Chinese corporations. Evidence shows that the aggressive economy-wide capital formation has been mirrored in the corporate world. The chart below summarizes aggregate corporate cash flow and fixed asset investment for China vs the U.S. The key is the wedge between operating cash flow and investment. In the U.S. there has been a systematic surplus of cash flow over and above investment. In China, this has not yet been the case as the impressive growth in earnings was essentially all fully absorbed by investment. Rewards to shareholders have been further diminished by the dilution of per share earnings via the issuance of new equity. But as investment tails off, less equity issuance will occur and more free cash flow will be available for distribution to shareholders. In the U.S., a more mature corporate sector has been throwing off significant free cash flow and making net distributions to shareholders 2 since the restructuring wave of the 198s. Where the cash is flowing Aggregate corporate cash flow and investment China s potential increase in free cash flows comes at a time when valuations in the Chinese equity market appear to have converged with the rest of EM (see chart below). The relatively high historical valuations in China have been the most important driver of the weak relationship of GDP growth with equity returns. Distortions in equity valuations persisted in China for a long time mainly because of the relatively small size of the market as a share of the economy. China s high historical valuations were also due to the dominance of retail investors, who still make up about 8 percent of the market, Bloomberg reported in May. But both of these factors have been gradually changing. The strong IPO pipeline over the past few years has increased the size of the market and the agenda to improve the connectivity of the Shanghai stock exchange with other financial centers is gradually turning the Chinese equity market into a more institutional one. Converging valuations Price to earnings ratios: EM vs. China PE Ratio 2 China Shanghai China fixed asset investment 5 MSCI EM 15 USD, log scale 1 China net operating cashflow U.S. cashflow Sources: Haver, CEIC and Bloomberg, December 216. For the reasons above, we believe China s growth not only 5 will be above average but that it is likely to be much more stock-market friendly than it has been in the past. This U.S. fixed asset investment implies the relationship between GDP growth and equity returns will become stronger over time Source: WorldScope, December See for example THE NEXT BIG THING IN EMERGING MARKETS 5

6 First, as the Chinese economy has been growing in complexity, it has been moving up the value-added chain, experiencing significant import substitution while grabbing a larger share of global auto production (see chart below). Moving up the value-added chain Economic complexity and global auto share 18 5 since 214 and is expected to overtake the U.S. position in 219, according to the latest OECD figures. Capital equipment imports from OECD countries increased 368% from 1995 to 28, which is unprecedented. 3 Furthermore, the sheer size of the Chinese market and the rapid adoption of mobile technologies has pushed online sales in China beyond those in the U.S. in 212. Online sales continue to grow at a rapid pace (see graph below). Economic complexity ranking Economic complexity ranking Share of global auto production Share of global auto production China goes shopping online Online sales, U.S. vs. China 5 4 Billion USD Source: The Atlas, Center for International Development at Harvard University, UBS estimates, 215. More generally, the adoption of technology in China has been an important driver of its economic transformation. China s annual R&D spending has exceeded that of the EU China U.S. Source: Research Institute of Economy, Trade, and Industry, December 215. Macroeconomic challenges The profound economic transformation that China is going through has created imbalances and policy challenges that need to be addressed sooner or later if the country is to continue on its path to prosperity. The list of potential concerns and things that could go wrong in China is relatively long. Most of them arise from the somewhat inexplicable desire to have an absolute number for economic growth as a policy objective and the insistence on keeping growth high at almost all costs. In some sense, China has been going against history by creating an unprecedented prosperity for a huge number of people using an alternative economic and political model. Although some would argue that China may be getting to a level of GDP per capita that will test the limits of this model, its track record of economic achievements over the past 3 years is impressive. More recently the model is starting to show different vulnerabilities, particularly with regard to the high levels of debt. History shows that credit booms such as the one that China has gone through since 25 tend to end badly (see chart on page 7). It is a danger signal that the increase of leverage in China may be happening at an earlier stage of development and at a faster pace than other countries where a similar pattern was observed and invariably ended in a major financial crisis. But it is also true that China, unlike other emerging economies, has a significant external surplus, and a relatively closed financial system making the risk of a financial crisis of the traditional sort relatively low. 3 See OECD, 212 Technological Upgrading in China and India: What do we know? 6 CHINA S ONSHORE EQUITY MARKETS

7 China s rising debt problem Private credit as a share of GDP 25 Private credit as a share of GDP Japan Thailand U.S. China Spain Source: BlackRock Investment Institute and Bank for International Settlements, June 216. It is unclear to what extent Chinese authorities are committed to financial reform and a full opening of their capital account, both of which are indispensable ingredients for successful financial market development. Reform has been one of the top priorities of the government and is a relevant component of their narrative. But the evidence and the results have been mixed. There has been a tendency, particularly in 216, to interfere in regular equity market dynamics, and the management of FX policy has sometimes lacked clarity and been poorly communicated. The excessive liquidity that has been required to sustain high levels of growth has also been creating significant capital outflow pressures. When so much wealth is created in a relatively closed economy, local participants try to diversify their investments in offshore assets. But it now appears that capital outflow pressures have somewhat abated as the demand for foreign currency to reduce external liabilities by the private sector has been trending down. The bilateral relationship with the US is entering a new and potentially more difficult phase, with the possibility of a trade war and increased geopolitical tensions. An escalation in tensions with the U.S. would certainly destroy economic value for both countries, but China may get the worst of it. China has been trying to diversify away from the U.S. by rebalancing its economy toward domestic consumption, and by creating an alternative multilateral financial system, but it would still be vulnerable in this scenario. THE NEXT BIG THING IN EMERGING MARKETS 7

8 Reform agenda and investment opportunity Although reforms are hard and cost political capital, Chinese authorities are well aware that reforming the economy is the only way to continue with sustained growth. Our custom indicators that track the intensity of discussion about reform in the People s Daily show that the terms supply-side reform and reduction in production capacity started to become relevant at the end of 215 and gained momentum throughout 216 (see charts below). A similar count of the number of articles shows that the Chinese government has also put strong emphasis on infrastructure investments, for both trade linkage with Asian and European countries and technology upgrades (e.g. 5G, cloud), which could be an important driver of future growth. As China continues to reduce its reliance on external demand it has also been pursuing an alternative multilateral approach by sponsoring new initiatives that rely less on the U.S. and Europe, such as the new Asian Infrastructure Investment Bank and the One Belt One Road initiative. Where the West appears to be drifting away from globalization and free trade, the recent initiatives to rebalance the economy away from investment alongside the new approach to multilateralism will make the Chinese economy more resilient to growing geopolitical tensions. Chinese exports have already gone from representing 37% of GDP in 26 to 22% in 216, World Bank figures show. China also has one of the strongest external financial positions in all of the emerging markets. Its current account surplus, low levels of external debt and significant base of domestic savings (see chart on page 9) may make China more resilient than other emerging economies in an environment where goods, services and capital are likely to move less freely across borders. The recent deterioration of the geopolitical environment is occurring at a time when the Chinese liberalization agenda has led the International Monetary Fund to include the Renminbi in the special drawing rights (SDR) basket in 216. A focus on reform and investment Articles in People s Daily containing related keywords Number of articles Supply side reform Number of articles One belt one road Capacity cut IT & big data development Source: People s Daily, BlackRock, December CHINA S ONSHORE EQUITY MARKETS

9 A strong external financial position Current account deficit vs gross national savings of selected countries 3.8% Current account deficit, % of GDP ARG ZAR BRA CRO POL HUN CHI PER ROM MX COL RUS TUR MAL UKR PHI IND INDO China % Gross national savings, % of GDP Source: Bloomberg, World Bank, May 217. Bubble size is determined by external debt to GDP ratio. Among other measures, Chinese authorities have introduced more flexibility to their currency market by adopting a currency basket that better resembles their import/export activity. Authorities have also accelerated the opening of the Chinese local equity market to more sophisticated institutional investors, mainly through the Hong Kong and Shenzhen connect initiatives. In fixed income, the central bank has already taken initial steps to facilitate the participation of foreign institutional investors in local bond markets. sectors like materials, industrials and financials. These new economy sectors make up less than 35% of the Chinese equity market, but represent close to 6% of the S&P 5 index (see chart below). However, their representation has been gradually improving since 27 as the new economy companies have gained share in the IPO market where they already drive more than 5% of all equity issuance. Growing role for new economy shares Sectoral makeup of major equity indexes Although liberalization has been moving more slowly than originally expected, it will eventually lead to the inclusion of the local A-Share market in the MSCI Emerging Markets index, broadening the representation of China in global capital markets and likely drawing additional inflows of capital. Along the same lines, China is already in the process of being incorporated into some of the main fixed income indices. 4 In terms of sector representation, the Chinese equity market is also likely to experience an important transformation in favor of new economy sectors that will drive future economic growth. Many of these are associated with consumption, services and technology and are less associated with more traditional and over-represented manufacturing-driven Index sector composition New economy Source: MSCI, December 216. EM World S&P China A Telecom services Health care Cons. staples Cons. disc. Info. tech. Real estate Utilities Industrials Materials Energy Financials 4 THE NEXT BIG THING IN EMERGING MARKETS 9

10 One fact that is often overlooked about the China A-share market is how large and idiosyncratic it can be, in the context of other emerging equity markets. The A-share market is already one of the most liquid in EM (see chart below) and its correlation to the U.S. and other major developed markets has been relatively low, at around.2. By the time the full integration of A-share market in the MSCI EM index is finished, China may likely represent more than 4% of all EM. 5 Over time, these attributes will make China more difficult to cluster with other equity markets for broader index representation and it may actually drive some portfolios to start thinking of China as a standalone market instead of part of EM. Chinese equities thus have the potential to become a standalone asset class. Large and liquid Size and trading volume of selected equity markets already captured in the main economic activity indicators. Most notably manufacturing and services PMIs turned positive in 216 and have been accelerating, making China one of the most important drivers of the recent global reflation trend. Optimistic on China Companies expressing positive view in conference calls 78% Positive vs. negative articles Trillion USD (market cap)/ Billion USD (average daily volume) Market cap U.S. EM China A Japan Number of liquid stocks Average daily volume 3, 2,25 1,5 75 Number of liquid stocks Oct 11 Oct 12 Oct 13 Oct 14 Oct 15 Oct 16 Source: FactSet & BlackRock, October 216. There is much at stake as China faces a global geopolitical environment that may continue to deteriorate at a crucial time in the country s economic history. As authorities prepare for the 19th Communist Party Congress to be held late in 217, there will likely be a special emphasis on maintaining stability and steady growth for the remainder of the year, while continuing to foster the financial reform and economic rebalancing that underpins the positive prospects of Chinese equity markets. Source: Bloomberg, December 216. Liquid stocks are those with average daily volume > US$5m. The improved prospects for Chinese equity beta are giving rise to some interesting trends. Global companies that have ongoing activities in China often discuss the economic and business outlook at their conference calls. After a difficult period in there is now a marked improvement in market outlooks as more companies are talking positively about China (see chart to the right). To some extent these improved outlooks relate to the coordinated fiscal and monetary policy initiatives that authorities have implemented and the consequent upturn in economic activity, which is Despite the economic and demographic challenges that China is facing, other structural conditions such as a large labor force and an ongoing urbanization trend will continue to support medium-term prospects for Chinese economic growth. And as China continues to experience above-average GDP growth, improvements in the structure of its equity markets are likely to foster a closer interaction between the economy and markets, a process we believe will make Chinese equities an attractive investment proposition. 5 See MSCI China A-Shares Index Inclusion Roadmap 1 CHINA S ONSHORE EQUITY MARKETS

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