The rallying cry that China is simply too significant a part of the world’s economy to leave out of a well-diversified portfolio is about to be last year’s cliché.
For the moment, the country remains the second largest economic engine in the world, but its stunning growth in just the past few years has investors taking bets on exactly when it will take the top spot.
Certain Canadian pension plans, including the Canada Pension Plan Investment Board, have become increasingly vocal about why they’re making inroads in China. “It’s not always well understood why CPP Investments has such strong interest in China,” says Michel Leduc, senior managing director and global head of public affairs and communications at the CPPIB.
“Most economists agree that in the next five to 10 years, China will overtake the U.S., so for us, it’s the risk of omission. If we were not exposed to China and we fast forward five to 10 years from now and people say, ‘Well, why didn’t you invest in China? It became the largest economy’ — that’s a risk if we didn’t do it.”
Further, with the CPPIB’s mandate to achieve a maximum rate of return without taking excessive risk, it has to account for the fact that many of the key factors driving its funding and sustainability are inextricably tied to Canada, he says, which creates a natural need to hedge that inherent weighty exposure to the Canadian economy. And of the many geographic diversifications strategically established by the fund, China offers markets that have maintained limited correlation with other major economies.
One likely reason for this is the fact there’s so little market activity from foreign investors in China so far, which is set to change as the country opens up its capital markets, further easing restrictions that have traditionally kept out foreign investors, says Qian Wang, managing director and chief economist for Asia-Pacific at the Vanguard Group Inc.
“The correlation is still much lower compared to the correlation between the U.S. and Europe, say, or the U.S. and smaller emerging markets. I think the key reason there is that the economic cycle within China and the rest of the world aren’t perfectly correlated because China has such a domestic economy. That’s where China’s economic cycle — and probably its monetary policy cycle — can afford to diverge from the global cycle.”
But apart from diversification, China is becoming a more evident source of alpha.
Indeed, during the coronavirus pandemic, Chinese domestic equities outperformed many other geographic clusters of stocks, says Lila Han, an associate partner at Aon. “If you look at China’s performance — because they were the first to get hit and therefore the economy is starting to open up much earlier than all the other markets during the first quarter — A-shares delivered about half of the market drawdown that the S&P 500 did. And it continues to outperform the rest of the developed markets and emerging markets year-to-date.”
She suggests that institutional investors looking to play the long game in China look to its domestic growth. “Consumer contributions to China’s domestic growth are rising and that will continue.”
The lion’s share
However, Han also notes Chinese stock trading is a completely different animal than what institutional investors focusing on largely developed markets are used to. The vast majority of the market is taken up by retail investors taking more speculative views than is typically common among institutional investors.
“Foreign institutional investor participation in the domestic equity market [is] around two to five per cent, depending on if you’re looking at a percentage of total market cap or free float market cap. So it’s a tiny portion and the retail participation is anywhere from 80 to 90 per cent of the market. It’s highly inefficient and there’s a lot of room for active managers who are willing to spend the time, effort and resources to uncover those alpha growth stories.”
As China develops its market infrastructure, it’s in its best interest to encourage institutional investors to take up more space in capital markets, she adds, noting its government is tweaking complex regulations to allow more participation. “We think this is in line with the policy-makers’ long-term focus to create more stability in their capital markets. That’s obviously good for everyone. And one way of doing that is really opening up more access channels and mechanisms to foreign institutions that are very much focused on the long term and that aren’t playing the market and speculating like a lot of their retail base.”
The wall’s still up
However, parts of the market remain incredibly opaque, says Aimee Kaye, investment analyst for emerging markets at MFS Investment Management. “Broadly speaking, I think China’s local fixed income markets have been pretty challenging for western investors in general for a few reasons. One is the learning curve vis à vis the structure of the economy, of policy-making and the way those are communicated, because it is so distinct from the U.S. and Canada.”
In seeking sufficient data for making decisions, she adds, China is tricky. “Investors — and myself as well — were watching a lot of high-frequency indicators during the peak of the crisis: things like electricity consumption, traffic congestion, air quality. There’s a lot of data out there, but China’s not a country where you’re going to be able to do things like track weekly initial jobless claims.
“You’re in this environment where investors tend to have to dive pretty deeply into the economic data and also spend quite a lot of time understanding the nuances of policy-making from the institutions, the regulatory bodies involved, the authorities who speak on those institutions’ behalf and even quite a complicated monetary fiscal framework that operates in the country. It’s by no means a simple market for foreigners.”
Just as equity markets are made up of a very different collection of investors, the landscape of bond markets is also quite one-sided, says Kaye, with the lack of foreign players remaining a key theme. “The market structure itself is quite different from what investors may expect when they’re looking at other developed markets or emerging markets. And one thing that’s of note is that foreign investors — especially compared to investors elsewhere in Asia — are still a pretty small share of that local fixed income market. It’s local banks that hold as much as 70 per cent of local government bonds and policy bank bonds and they largely hold those to maturity. So foreigners tend to have to be pretty careful about what specific bonds they’re buying and where there’s the liquidity.”
As for more direct private investments, Wang says it’s less clear where capital flows from foreign sources will go from here. The pandemic has certainly disrupted activity in the short term, but she notes investments of this kind have been slumping as the broader trend of de-globalization takes hold.
“For example, the U.S. has been trying to bring manufacturing back to the U.S. and I think the virus shock is accelerating the trend because there is concern about over-reliance on supplies for many of the products and industries that are considered essential. So there are some general concerns of, ‘Will business stop coming to China?’ in terms of that kind of direct investment.”
In the past, manufacturing has been the driver of international dollars into China’s economy, but as the country’s labour costs climb, businesses are looking to cheaper markets like India, Mexico and Vietnam, says Wang. “But I think it’s more about the total investment into China and also about why and where people are investing in China.”
Ultimately, domestic demand for goods and services has driven China’s growth into the world’s second largest economic player and will be the factor that underpins the strength in investments made by institutional investors going forward, she says.
But China is still a risky market, adds Wang, and wading into it could offer significantly higher returns if investors have the risk appetite. As they go up the risk curve, they’ll need to tackle a serious learning curve as well. “For foreign investors to get comfortable investing in China and other emerging markets, they really need to be there and understand more about the investing environment. So I think they need to gain a lot more knowledge about the country.