We have talked for weeks about the China “MMA” or mutual market access event with a tone of excitement.
Well that event began last night as Chinese local market opened up and investors in Hong Kong were able to participate in buying (and s4eling) local Chinese stocks (FXE, quote). The size of the markets trading in Hong Kong and in China are over $5 Trillion Dollars but remain vastly under-represented in terms of their percentage of the overall MSCI EM index (EEM, quote).
The markets have drastically underperformed emerging markets despite containing key ways to play China consumption growth which continues whether China GDP is 10% of 5%. We know this event is a big deal for local Chinese investors but the liberalization of China’s stock markets also presents opportunities for global investors. We see two primary drivers for potential outperformance of a China allocation for global investors:
- Global index benchmarking
We continue to argue that China’s stock markets are driven more by liquidity than macro-economic data. China is a momentum play and also a play on whether there is liquidity being generated by policy makers to stimulate domestic access to cash.
Often this additional liquidity in the local markets will need home and typically it has been the property market or the local stock market. Chinas stock markets are also a function of the closed nature of the local markets which prevents global capital from allocations to local Chinese stocks. I can’t tell you how many requests I have fielded as an advisor over the years from investors who are looking to play domestic consumption in China.
These same investors are NOT interested in playing the large SOE’s that they can get access to in Hong Kong or via the ETFs like FXI. Because of the limitation in the access significant flows are turned away at the door. Local Chinese stocks (China A Shares) trade at a multi-year low valuation of 11.5X current earnings.
From a global benchmarking perspective, the market connect event may give global players another reason for buying Chinese stocks. Chinese A Shares may finally be included in the MSCO EM index if opening up the market means removing one of the primary barriers to full inclusion in the MSCI EM.
Right now china is about 19% of the MSCI EM despite being a market that has about 30% of the overall weight total EM market cap. The MSCI has said on numerous occasions that they will review China for inclusion in the index when they have removed restrictions upon ownership. Back in June of 2013 the MSCI put China on review for inclusion and in March of this year indicated a path China could follow for a 5% inclusion in the MSCI EM Index.
It is speculated that a full inclusion of China would equal a fresh allocation of almost $150Bn in capital flows. In the short run we see even a 5% inclusion (target June 2016) as equaling 10Bn right away. We think the market will price this in before the event.
In the short run we continue to endorse a larger allocation even to the FXI ETF which tracks the HK listed large cap Chinese stocks. We believe that the move to small and mid-cap stocks in China will see some limitation in terms of capacity and we see this event bringing more capital flow overall to China with a need for larger companies and market cap opportunities. The FXE still is the best way to play big cap China but is clearly tilted towards the banks and the larger industrial and mining plays.