China s benchmark inclusion Time to decide July 2018 For Professional Investors only The value of an investment in the portfolios and any income from them can go down as well as up and as with any investment you may not receive back the amount originally invested.
While China has been leading global economic growth for over a decade, the last few years have seen particularly significant changes. China s economy is undergoing a major transformation from an investment-driven to a consumption-driven growth model; its financial and capital markets are opening up and evolving rapidly; and its explosive growth in technology has pervaded almost every aspect of the economy, as well as people s daily lives. These changing dynamics are creating a plethora of new opportunities as revenues increase, profitability improves, consumption patterns change and investment trends evolve. Interestingly, many of these opportunities can only be accessed by investing in mainland Chinese markets, rather than through offshore-listed securities. China s financial and capital markets are opening up and evolving rapidly, creating a plethora of investment opportunities Why now? While most global investors have been acutely aware of China s growing economic power, few have so far made significant allocations (see page 2). In that respect, the inclusion of mainland Chinese securities into some of the world s most widely tracked indices is a game-changer. Indeed, a vast majority of investment portfolios around the world are benchmarked against these indices, meaning they are likely to increase their mainland Chinese holdings substantially over the next few years, both in equities and fixed income. The coming months therefore present a unique opportunity for investors to decide whether they want to begin allocating to the world s second-largest equity market and third-largest bond market before global allocations inevitably pick up pace. China s markets are complex and constantly changing, but they are also extremely large, and attractively valued. Combined with the diversification benefits they offer, this makes them a compelling investment opportunity which can no longer be ignored. Consumption is now the major contributor to real GDP growth China is the world s biggest market for electric vehicles 10 8 6 4 2 0-2 -4-6 1998 2001 2004 2007 2010 2013 2016 800 600 400 200 0 '000 units 2011 2012 2013 2014 2015 2016 2017 Consumption Investments Net exports New energy vehicle production New energy vehicle sales Source: Bloomberg, data as of January 2018 Source: Bloomberg as of January 2018 1
Limited investability has allowed investors to ignore China so far Many investors have so far remained wary of investing in China, because of perceived idiosyncratic risks and concerns about local market controls and regulations. Coupled with access restrictions and lack of liquidity, it has been enough to deter most investors from taking exposures to the country. Investors reticence and limited investability also made it difficult for the major index providers to include onshore Chinese securities into global, regional and even emerging market indices to any significant degree (see charts below). However, over the last 16 years, China has taken a number of steps to improve its markets accessibility, depth and liquidity. While the pace of these reforms has been intentionally cautious, global index providers have rewarded China s efforts with long-awaited decisions to include onshore securities into their indices. Market-oriented reforms aim to encourage global fund flows into renminbi assets Chinese bonds represent about 10% of the global bond market Bond outstanding in USD trillion 40 35 30 25 20 15 10 5 0 300% 250% 200% 150% 100% 50% 0% and account for less than 1% of the BBG Barclays Global Aggregate Index 99.3% 0.7% Total bond outstanding, USDtn Total bond O/S as % GDP China rest of the world Source: BIS, IMF, latest data as of June 2018 Source: Barclays Point, data as of June 2018 Chinese equities represent about 15% of the global equity market Market capitalisation in USD trillion 35 30 25 20 15 10 5 0 and account for about 5% of the MSCI AC World Index 94.93% 5.03% 0.04% China China-A rest of the world Source: World Federation of Exchanges, data as of June 2018 *From bottom to top: US = NYSE + NASDAQ; China = SSE + SZE + HKEx; India = BSE + NSE Source: MSCI, Bloomberg, data as of June 2018 2
Stock Connect programmes: Stock Connect allows international and Mainland Chinese investors to trade securities in each other's markets, via Hong Kong. First launched In November 2014, the scheme now covers over 2,000 eligible equities in Shanghai, Shenzhen and Hong Kong. Existing programmes are between Shenzhen and Hong Kong on the one hand, and between Shanghai and Hong Kong on the other (source: http://www.hkex.com.hk/mutual-market/stock- Connect?sc_lang=en). Bond Connect programme: Bond Connect is a mutual market access scheme that allows investors from Mainland China and overseas to trade in each other's bond markets through connection between the related Mainland and Hong Kong financial infrastructure institutions. Northbound Trading commenced on 3 July 2017, allowing overseas investors from Hong Kong and other regions to invest in the China interbank bond market (CIBM) through mutual access arrangements in respect of trading, custody and settlement. Southbound Trading will be explored at a later stage (source: http://www.chinabondconnect.com/en/index.htm). Northbound designates the direction (of funds or flows) from Hong Kong to onshore Chinese markets Southbound designates the direction (of funds or flows) from mainland China to Hong Kong markets 3
China has radically improved investability, from liberalisation to governance Since 2002, China has undertaken a complete transformation of its capital markets, gradually opening them to foreign investors through QFII and RQFII quotas, and ever-larger Stock Connect and Bond Connect programmes. It has also taken significant steps to improve governance within State-Owned Enterprises, which account for a large proportion of stocks and bonds in China s capital markets. Chinese market liberalisation is now expanding from capital markets (via RQFII, Stock and Bond Connect) to financial sectors (e.g. increasing foreign ownership limits), capital account management and trade, and will not stop there. This year alone, the People s Bank of China announced the creation of a London-Shanghai Stock Connect before the end of 2018 and the unprecedented allocation of a RMB200 billion RQFII quota to Japan, and expressed a positive attitude towards setting up a renminbi clearing bank in Tokyo. As a result, foreign ownership of onshore Chinese securities has scaled new highs in recent years, though they still remain small relative to the size of their respective markets (see chart). Chinese market liberalisation will not stop here China s financial market liberalisation 2002 QFII introduced 2007 First offshore RMB bond issued in Hong Kong 2011 RQFII introduced 2014 Shanghai-Hong Kong Stock Connect 2015 China/HK Mutual Recognition of Funds 2016 Simplified CIBM Registration Easier access regulations for foreign investors Shenzhen-Hong Kong Stock Connect RMB added to the IMF s SDR basket 2017 Bond Connect details announced Foreign credit rating agencies permitted to rate onshore bond issues Bloomberg Barclays Global Aggregate Index announces inclusion of onshore RMB bonds 2018 from April 2019 MSCI includes 226 China A-shares into its indices Foreign ownership of Chinese assets USD billion 400 350 300 250 200 150 100 50 0 Jan-14 Jan-15 Jan-16 Jan-17 Equities Bonds Source: HSBC Global Asset Management, JPMorgan and Bloomberg as at June 2018. 4
Major bond and stock indices are now including China These improvements have paved the way for China to join the ranks of global financial markets. MSCI have included China A-shares (i.e. onshore equity) in their Emerging Markets Index, while Bloomberg-Barclays has announced they will include onshore Chinese bonds in some of their new global bond indices from April 2019. This will have important consequences for global investors. MSCI has included 226 China-listed A-shares in several indices, notably its Emerging Markets Index, with a 2.5% inclusion factor from 1st June, to be increased to 5% on 3rd September. A-shares will then represent 0.8% of the MSCI Emerging Markets Index. Foreign ownership of onshore equities has already grown by 70% year-onyear, to USD190 billion, but still accounts for only 2.7% of China A-shares total tradable market. We expect flows to pick up meaningfully in the coming years, particularly as the Chinese government continues its efforts to deregulate the market and address other lingering concerns. In April the Chinese government quadrupled the northbound and southbound daily quotas under Stock Connect to RMB52 billion and RMB42 billion respectively in anticipation of the rise in foreign demand. This was well received. Net northbound flows picked up in April (+USD6 billion) and hit a record high in May at USD7.97 billion despite the selloff in the broader emerging markets, although they have since moderated. Foreign ownership of onshore equities has grown by 70% year-on-year China s financial market liberalisation Benchmark Inclusion factor: 2.5% (1st of June 2018) MSCI indicates that its All-Country World, Emerging Markets and Asia indices are tracked by USD5.3 trillion of assets. According to estimates, the initial inclusion should trigger flows of c. USD20 billion into the onshore equity market, so its immediate impact will be negligible China s onshore equity market capitalisation is USD6 trillion dollars, with an average daily turnover of USD44 billion. However, the eventual full inclusion of these stocks would increase their representation in the MSCI EM Index to around 17%, attracting several hundred billions in flows into the onshore market. Some analysts even suggest that foreign-owned China A-shares could rise to USD300 billion as the weighting gradually rises in coming years. In fixed income, the Bloomberg Barclays Global Aggregate Index will include onshore RMB bonds, which will make up 5.49% of the index. While we do not think the inclusion will trigger a re-rating of onshore bonds in the short term given the size of the Chinese bond market, and the fact that foreign participation remains below 2%, the long-term trend is positive for onshore RMB bonds, particularly once other major index providers follow suit. China A share % in the index Inclusion factor: 5% (1st of September 2018) MSCI Emerging markets Index 0.39% 0.78% MSCI Emerging markets Far East Index 0.58% 1.16% MSCI All Country Far East ex Japan Index 0.48% 0.96% MSCI China Index 1.20% 2.40% Source: MSCI, March 2018. For illustrative purposes only. 5
To allocate, or not to allocate? That is the (pressing) question This development has created a decision point for investors. Foreign fund managers who follow the benchmark will now need to buy into the Chinese stock and / or bond markets, or else deviate from the index. Investors who are worried about China s investability and future may need to change their strategic asset allocation benchmarks to avoid taking additional exposure to the country. On the other hand, investors who are comfortable with the increased weight of China in their benchmarks or those who want to seize the opportunity to increase their exposures further should act now to get ahead of the rebalancing crowd. Based on past precedents, where it took around seven to ten years for Korean and Taiwanese stocks to be fully included into MSCI indices, the pace of inclusion for A-shares will be driven by the continued progress of China s market liberalisation programme. While we have seen major developments on this front, such as the launch of the Connect programmes and most recently, the loosening of foreign ownership limits on the financial sector, other areas of concern remain, such as capital controls and the trading suspension mechanism, and those still need to be addressed. Full A-share inclusion could therefore take several years. In contrast, the inclusion of onshore government and policy bank bonds will only take 20 months. While asset managers who track MSCI indices are on average still underweight Chinese equities, they have been increasing their allocations to the country s stocks since early 2016. They will have to step up these efforts progressively to accommodate the inclusion of A-shares, but also their potentially larger presence in key MSCI equity indices in future. Those who track the Bloomberg Barclays Global Aggregate index will have a number of options to choose from: follow the index as it changes, be proactive and increase their China allocation ahead of the index adjustment, choose to be laggards and allow for a larger tracking error whilst the adjustment is embedded by the markets, or change their benchmark. Foreign investors will need to buy into the Chinese markets if they don t want to deviate from their indices 6
How we can help HSBC Global Asset Management is one of the pioneers in the A-share market, managing USD3.3 billion for its clients. HSBC Jintrust s large-cap onshore fund is now the largest southbound A-share fund available to offshore investors and accounts for 63% of total market share under the Mutual Recognition of Funds scheme. 1 Our onshore and offshore equity strategies employ a proprietary investment process to identify undervalued stocks with sustainable profitability. While we have always taken off-benchmark positions in A- shares, in 2016 we added flexibility to enable our offshore strategies to substantially scale up their investments in onshore equities. Since 1996, our Asian fixed income strategies have been following a focused and disciplined investment process that aims to identify investment opportunities arising from Asian fixed income markets. As these markets develop, they generate short-term inefficiencies which our dedicated investment teams 22 managers, 12 analysts exploit to deliver superior risk-adjusted returns for our clients. A network of opportunities 79 Americas Presence in 26 countries and territories $481.7bn under management 141bn Asiapacific Around 600 investment professionals 160 Asiapacific 2 348 EMEA Canada USA Mexico Bermuda Switzerland Luxembourg UK Jersey France Spain Sweden Germany Austria Malta Italy Saudi Arabia Turkey UAE India China 2 Japan Taiwan Hong Kong Singapore Australia Argentina HSBC Global Asset Management offices 1. Source: HSBC Jintrust, data as of 30 April 2018 2. Asia-Pacific includes employees and assets of Hang Seng Bank, in which HSBC has a majority holding. Source: HSBC Global Asset Management as at 31 March 2018. Any differences are due to rounding. 7
HSBC Global Asset Management Asian investment capabilities Asian Equities Regional Asia ex Japan equity Asia ex Japan equity (smaller companies) ASEAN equity Asia Pacific ex Japan volatility-focused equity Asia Pacific ex Japan high-dividend equity Emerging Markets Far East equity (passive) Single country Chinese equity (active and passive) Indian equity Hong Kong equity Taiwan equity (active and passive) Thailand equity Korean equity (passive) Indonesian equity (passive) Malaysian equity (passive) Asian Fixed Income Regional Asian credit (Investment-grade and high-yield) Asian currencies Single country Offshore China fixed income Onshore China fixed income Indian fixed income Indonesian fixed income Hong Kong fixed income Singapore fixed income Asian Multi-Asset Regional Asia Focused Series Single country China Multi-Asset Income Asian Liquidity Single country Australia China Hong Kong India Taiwan 8
Key risks The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Exchange rate risk: Investing in assets denominated in a currency other than that of the investor s own currency perspective exposes the value of the investment to exchange rate fluctuations Liquidity risk: Liquidity is a measure of how easily an investment can be converted to cash without a loss of capital and/or income in the process. The value of assets may be significantly impacted by liquidity risk during adverse market conditions Emerging market risk: Emerging economies typically exhibit higher levels of investment risk. Markets are not always well regulated or efficient and investments can be affected by reduced liquidity Derivative risk: The use of derivatives instruments can involve risks different from, and in certain cases greater than, the risks associated with more traditional assets. The value of derivative contracts is dependent upon the performance of underlying assets. A small movement in the value of the underlying assets can cause a large movement in the exposure and value of derivatives. Unlike exchange traded derivatives, over-the-counter (OTC) derivatives have credit and legal risk associated with the counterparty or the institution that facilitates the trade Operational risk: The main risks are related to systems and process failures. Investment processes are overseen by independent risk functions which are subject to independent audit and supervised by regulators Concentration risk: Funds with a narrow or concentrated investment strategy may experience higher risk and return fluctuations and lower liquidity than funds with a broader portfolio Interest rate risk: As interest rates rise debt securities will fall in value. The value of debt securities is inversely proportional to interest rate movements Derivative risk (leverage): The value of derivative contracts depends on the performance of an underlying asset. A small movement in the value of the underlying can cause a large movement in the value of the derivative. Over-the-counter (OTC) derivatives have credit risk associated with the counterparty or institution facilitating the trade. Investing in derivatives involves leverage (sometimes known as gearing). High degrees of leverage can present risks to sub-funds by magnifying the impact of asset price or rate movements Emerging market fixed income risk: Emerging economies typically exhibit higher levels of investment risk. Markets are not always well regulated or efficient and investments can be affected by reduced liquidity, a measure of how easily an investment can be converted to cash without a loss of capital, and a higher risk of debt securities failing to meet their repayment obligations, known as default High yield risk: Higher yielding debt securities characteristically bear greater credit risk than investment grade and/or government securities Contingent Convertible Security (CoCo) risk: Hybrid capital securities that absorb losses when the capital of the issuer falls below a certain level. Under certain circumstances CoCoscan be converted into shares of the issuing company, potentially at a discounted price, or the principal amount invested may be lost 9
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