Should investors consider stand-alone allocation in China?

Despite ongoing trade tensions, there are still reasons to expect higher returns from an active approach

By Leo Almazora

Jan 03, 2019

2018 was a tough year for China especially as international relations came into the spotlight. With the US and other countries taking a distrusting posture toward the Asian country, investor sentiment soured as doubts on the government’s ability to deal with both a trade war and deleveraging — without sustaining a hit to growth — take hold.

Still, that does not mean the country’s growth prospects aren’t promising. “Despite expectations that growth will slow, in our base-case scenario China is expected to grow 6.5% in 2018 and around 6% in 2019,” analysts from State Street Global Advisors said in a commentary. “This compares favorably with an average of 2.4% for advanced economies in 2018 and 2.2% in 2019.”

The analysts noted that the country is also rebalancing toward domestic consumption and services-oriented sectors, all as it pursues a path of economic reform and opening up. Aside from policy efforts to avoid a hard landing, they pointed out that the 2018 selloff has resulted in attractive equity valuations across China as seen in the forward price-to-earnings ratio of the MSCI China Index.

“While some may argue that these stocks are cheap for a reason, we think certain sectors look worth investigating within a framework of active management,” State Street said. They cited IT, communications services, materials, industrials, and real estate as areas where their active fundamental team was underweight; they were overweight in consumer discretionary stocks, amid rising wealth and disposable incomes, and had small overweights to energy and healthcare.

Turning to Chinese bank valuations, the analysts noted price-to-book ratios that were will under 1x and a yield around 5%, which spelled limited prospects of further downside. Against the dissipating impact of US fiscal measures, emerging-market earnings appear poised to revert above those of developed markets. Should a settlement be reached between the US and China, the firm said, the gloom overshadowing global equity markets would lift — and Chinese equities would emerge among the biggest winners.

Another trend that investors should watch out for, the firm added, is the potential inclusion of onshore Chinese securities in major emerging-market equity and debt indexes following a phased approach from 2019.

“From an equity perspective, MSCI is proposing to add a higher proportion of China A-shares (traded onshore in China) to its broadly followed MSCI Emerging Market and China indices,” it noted. “Such index changes plus the advent of the Stock Connect program (that links onshore and offshore markets) should render the distinction between the two types of shares (A and H) irrelevant.”

With that view, the firm saw potential for global investors to run a unified all-share China equity strategy. Since higher-quality and investable Chinese companies tend to be listed offshore and the two types of shares can differ greatly in valuation, a unified strategy may be preferable to a separate A-share only strategy.

“Given the potential inefficiencies in this market, we would recommend investing in China with a skilled active manager who is able to capture the maximum alpha available,” the analysts wrote.

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