Chinese equities listed in mainland China and in Hong Kong have been through an impressive rally over the past few weeks, and the momentum has accelerated lately. Out of all major stock market indices in the world, the CSI300 that tracks down the Shanghai and Shenzhen stock markets has been so far this year and for the second year in a row one of the best performing indices, up 16.0% year-to-date as at 10^th July 2020, second only to the Nasdaq index, up 18.3% year-to-date.

Since the global market trough that was hit in the third week of March, the CSI300 index rallied by 34% and the MSCI China by 41%, while the S&P500 rallied by 42% and the Eurostoxx 50 by 38%. The Chinese rally has certainly been impressive, but it was not isolated.

Why is this happening?

By opposition to widely-held US tech stocks that dominate the Nasdaq, Chinese equities are massively under-owned by global investors despite the Chinese equity market being the second largest market in the world. China’s A share market is USD9.4 trillion. The Hong Kong market is USD5.7 trillion, and Chinese ADRs listed in New York are another USD1.5 trillion. That’s a combined market cap for Chinese equities of USD16.6 trillion. By comparison, the US market size ex-ADRs is USD33.9 trillion, Japan is USD5.7 trillion, the UK is USD2.6 trillion and France is USD2.3 trillion, as at 10^th July 2020.

Even though China has opened up its domestic financial markets and let foreign investors participate through the Stock Connect channel since 2014, foreign investors only represented so far this year 4.9% of the A share average daily turnover of USD114.5bn, up from 4.0% in 2018 and 2.7% in 2017. Admittedly there were many reasons to avoid this market, be it the China-US trade war, the Hong Kong riots of 2019, or the initial Covid-19 outbreak in China. This comes in addition to the perennial reasons put forward for the past 20 years or so by a large proportion of investors who remain suspicious, if not outright hostile to the idea of investing in this country. Arguably, this is largely due to a limited understanding of what China is today and of the transformation that the country has been through over the past couple of decades. Reasons put forward are often misplaced or outdated, and typically include, in random order, a property bubble highlighted by the existence of ghost towns, the risks attached to the shadow banking sector, an overly leveraged economy, a currency that is perceived as manipulated, the untrustworthiness of the accounting system, macro numbers that no one should believe in, poor corporate governance, and of course the fact that China is an authoritarian regime ravaged by corruption and favoritism. With such ideas being so widespread, it is not a surprise that Chinese equities listed anywhere in the world have remained massively under-owned by foreign investors for as long as anyone can remember.

What has triggered this rally?

The first factor is the liquidity injection of the Fed and the ECB. In the US only, USD3.7tn have already been spent to protect the US economy against the impact of Covid-19, which is equivalent in today’s dollars to 20x the cost of the Marshall Plan at the end of the second world war that helped rebuild Europe and 4x the cost of the Vietnam war, according to economists at Gavekal. In six weeks during March and April this year, the Fed bought more US Treasury bonds than it did during its first three batches of quantitative easing (QE1, QE2 and QE3) when it dealt with the global financial crisis and its aftermath.

Globally, quantitative easing is expected by Fitch to reach USD6tn in 2020. This massive exercise of money printing is unprecedented in history, and is combined with a succession of interest rate cuts that led rates to become negative or close to zero across the developed part of the world. In the United States, M2 is currently growing at the pace of 25% YoY, the highest rise ever recorded, and there is no indication by the Fed that this will end anytime soon. This liquidity needs to be invested. As we saw with previous QE exercises, beneficiaries are real estate, art works, gold, classic cars, vintage wine and other collectible items that are value safe havens, leading to a further widening of the global wealth gap.

When it comes to financial markets, key beneficiaries are markets where real interest rates are positive and currencies are stable. As institutional investors favour deep markets with high levels of liquidity, China is today the destination of choice. China’s 10-year bonds currently yield 200bps more than a 10-year US Treasury bond and 330bps more than a 10-year German bund, which explains why the RMB has embarked in a structural strengthening path against the US dollar and the euro.

The second factor is the macro picture of China. The country was the epicentre of the Covid-19 outbreak, and is now in full recovery mode. Bouts of outbreaks as the ones we saw recently in Beijing and in Hebei province were swiftly dealt with through immediate lockdowns. The economy is on its path to recovery, such recovery being largely driven by domestic demand. In June, most economic indicators flashed green, with growth being recorded on a year-on-year basis across all critical sectors. This is particularly true of the vast property sector (sales were up 13.8% YoY in June for the top 100 developers) and the equally important auto sector (sales up 11.6% YoY in June).

Stimulation so far has been limited to a series of tax breaks and to small cuts in policy rates. There is no indication that PBoC is willing to embrace unconventional western monetary policies, quite the opposite. As a result ammunitions in terms of policy tools remain aplenty and will most likely not be used as long as the rest of the world is not back on its feet. It is very likely that China will end up being one of the very few countries in the world with a positive GDP growth in 2020.

The third factor is the undemanding valuation of A shares. The CSI 300 index that tracks companies listed in both Shanghai and Shenzhen is currently trading at 15.5x this year’s estimated earnings, compared with a 5-year average of 12.8x. Earnings per share are expected by Bloomberg to rise by 21.9% this year. By comparison the Euro Stoxx 50 index currently trades at 20.1x this year’s earnings (5-year average is 14.3x) with an EPS growth this year of 21.6% while the S&P 500 index trades at 25.1x (5-year average is 18.0x) with an EPS growth of 0.6% only. Despite the recent rally, China remains inexpensive.

The fourth factor is the underweight of China is all global portfolios for reasons highlighted above that are, in our views, largely outdated, misplaced or misunderstood. There are today powerful forces that play in favour of China, in addition to the liquidity-driven influx of cash that will carry on as long as the ECB and the Fed keep on printing money and as long as the interest rates spread between China and developed markets remain in the triple-digits range.

Interestingly, and for sure counter-intuitively,  by pushing its anti-China rhetoric the Trump administration has accelerated the process of raising the inclusion of Chinese equities in global portfolios. The more the US shuts down to the rest of the world, the more China opens up. It is particularly true for the financial sector: Since the start of this year foreign banks and insurance companies can operate wholly-owned subsidiaries in China and conduct any activity. Following the success of the Stock Connect, China recently launched the Bond Connect that lets foreign investors participate without restrictions in the local RMB denominated bond market. On the equity side, the ChiNext and STARBoard markets were recently set up to cater, among others, to foreign companies willing to be listed in mainland China.

The trend will no doubt accelerate further in the coming years as the US Senate has decided to expel all Chinese companies listed in the United States through American Depository Receipts (ADRs) that do not comply with US audit rules, such rules being structurally incompatible with Chinese law. We expect to see the vast majority of the 250 Chinese companies listed in the US and representing USD1.5 trillion of market capitalisation apply for a secondary listing in Hong Kong, Shanghai or Shenzhen in the coming months and de-list from the US. Alibaba, Netease and JD.com have already done so. Once listed in Hong Kong, they will very likely be fast-tracked into the Stock Connect program that allows mainland Chinese investors to participate. Given the open threat of a US delisting, MSCI indices and all tracker funds will have to follow suit and replace their ADRs with their China/Hong Kong listed counterparts, adding to the existing liquidity of local markets.

It is then likely that MSCI will further raise the inclusion factor of A shares in its indices. The latest phase of such inclusion was in November 2019 when A shares reached 0.5% of the MSCI World Index, and 4% of the MSCI Emerging Markets index. However the MSCI inclusion factor today is only 20%. In other words, the weighting of A shares in MSCI indices will, one day, be 5x larger than it is today. MSCI is waiting for the Stock Connect liquidity to rise before it pushes further its inclusion factor of A shares. The stars are now aligned for such an event to happen sooner than later.

Where do we stand today?

To summarise our thoughts, we were not surprised by the strong market performance of Chinese equities in 2020. We had been writing about the logical impact of quantitative easing by the ECB and the Fed on Chinese markets since March this year. However what surprised us was the sudden acceleration of the past few weeks which has already led the Chinese government to step in to cool down exuberant behaviours. Indeed it took notice of the recent rise in margin financing activity as total margin financing balance reached RMB1.30tn as at 10^th July, up 44% from its 2019 average. This level of margin financing is still 57% lower than its 2015 peak level. Nevertheless the Chinese market regulator took swift action a few days ago and cracked down against the margin financing activity of 258 brokers. Memories of the 2015 market crash remain vivid in Beijing. We tend to believe that mistakes of the past will not be repeated.

Despite the short term excessive market movement that we do not feel comfortable with and that warrants a healthy market consolidation, we believe the combination of unlimited money printing in the West with the traditional approach of PBoC towards its monetary policy (by opposition to the unorthodoxy of the ECB and the Fed), the rebound of the Chinese economy and the unintended consequences of the US anti-China rhetoric on domestic market liquidity has a real chance of finally putting the under-owned equity markets of China on the map of foreign investors.

Nevertheless it is also likely that many China-bears will always remain China-bears, whatever the circumstances. This will turn the price discovery process into an interesting tug-of-war full of opportunities for visionary investors.

Sources for all numbers: Bloomberg