In this instalment, we look at whether Chinese asset prices reflect risk appropriately and whether expected returns will remain favourable over the long run.

Capital markets with Chinese characteristics

Low level of foreign participation. This is in relation to the size and influence of China’s economy, as well as compared to domestic investor activity.

Asymmetric capital-account opening. Money can flow more easily into China but there remain significant restrictions to domestic flows out of the country.

Growth and policy cycle that, at times, can de-synchronise from rest of the world. Our in-house tools show us that China’s economy can carve out its own path.

Domestic factors often more important than overseas developments. For example, companies in the onshore equity market derive more than 90% of their revenue from inside China.

How could this translate into performance?

We’ve simulated the historical return of a 50% equity, 50% bond, China multi-asset (MA) portfolio – with 25% each allocated to onshore equities, offshore equities, onshore bonds and offshore bonds.

During a 15-year sample period – June 2006 to November 2021 – this portfolio would have comfortably outperformed a 50/50 global MA portfolio on both an absolute and risk-adjusted basis.

Furthermore, the return/risk ratio of the global MA portfolio would have been improved if it had been combined with the China MA portfolio.

In the most recent three-year period, the China MA portfolio managed to achieve a similar level of risk-adjusted return as the global MA portfolio, even though Chinese trend growth had slowed.

Regulatory change (and other risks)

Chinese policymakers stunned investors last year with a series of unexpected regulatory interventions that rocked the real estate, technology and private education sectors.

Shocks such as this one have interacted with other concerns – market and corporate governance issues, concerns about the rule of law, geopolitical tension with the US and Russia’s invasion of Ukraine – to create market turbulence.

So there are clearly risks when investing in China, as there would be in any market. We need to assess those risks and judge whether they’re still worth taking.

Long-term impact by asset class

Measures to deleverage the property sector and to stop financial technology firms from engaging in regulatory arbitrage – evading the stricter rules that govern financial institutions – should reduce risks in the medium-to-long term.

However, these actions are also a reminder that sudden shifts in regulatory boundaries could imply higher risk premia in markets, higher hurdle rates for firms’ investments and, more generally, increased market sensitivity towards perceptions of the authorities’ goals.

We’ve analysed the data and here’s our latest thinking across equities, sovereign and corporate bonds:

Offshore equity. Lower prices reflect a fair amount of regulatory uncertainty given that some 40%–50% of the MSCI China Index is directly exposed to regulatory actions (i.e. internet, education and real estate). An additional discount is likely to be a result of renewed headwinds this year, such as spill-over risk from sanctions on Russia and economic disruption from China’s zero-Covid policy.

There’s at least a 25% upside for rerating should these macro headwinds recede. Once earnings expectations stabilise and the impact of regulation can be quantified by bottom-up analysis, investors may find current valuations attractive.

Onshore equity. Valuations have been less affected because the internet, education and real estate sectors only represent some 3% of the CSI 300 Index. More importantly, domestic investors don’t think current regulatory change will impair prices in the long run.

This remains our preferred asset class to tap into China’s long-term growth story. However, investors will need to pay close attention to the impact of regulatory change on corporate profitability.

Sovereign bonds. Chinese government bond (CGB) risk remains modest. In fact, the market has been relatively calm by historical standards. That’s not surprising since this market is driven primarily by fundamental factors – fiscal health, financial stability, external balance and easing monetary policy. A sovereign default seems very unlikely, even if the property sector suffers a hard landing. CGBs can offer an attractive diversification option, especially with the central bank’s relative independence.

Corporate bonds. Badly affected by regulatory change – property developers are big issuers and poor sentiment around the sector has spread to other issuers, regardless of quality. However, given our assessment that troubled developer, China Evergrande, won’t be a ‘Lehman moment’, we don’t think current bond yield spreads represent a ‘new normal’.

In fact, we think corporate bonds represent an opportunity for active investors who can exercise careful credit selection and time the market to profit from this aberration

In this instalment, we look at whether Chinese asset prices reflect risk appropriately and whether expected returns will remain favourable over the long run.

Capital markets with Chinese characteristics

Low level of foreign participation. This is in relation to the size and influence of China’s economy, as well as compared to domestic investor activity.

Asymmetric capital-account opening. Money can flow more easily into China but there remain significant restrictions to domestic flows out of the country.

Growth and policy cycle that, at times, can de-synchronise from rest of the world. Our in-house tools show us that China’s economy can carve out its own path.

Domestic factors often more important than overseas developments. For example, companies in the onshore equity market derive more than 90% of their revenue from inside China.

How could this translate into performance?

We’ve simulated the historical return of a 50% equity, 50% bond, China multi-asset (MA) portfolio – with 25% each allocated to onshore equities, offshore equities, onshore bonds and offshore bonds.

During a 15-year sample period – June 2006 to November 2021 – this portfolio would have comfortably outperformed a 50/50 global MA portfolio on both an absolute and risk-adjusted basis.

Furthermore, the return/risk ratio of the global MA portfolio would have been improved if it had been combined with the China MA portfolio.

In the most recent three-year period, the China MA portfolio managed to achieve a similar level of risk-adjusted return as the global MA portfolio, even though Chinese trend growth had slowed.

Regulatory change (and other risks)

Chinese policymakers stunned investors last year with a series of unexpected regulatory interventions that rocked the real estate, technology and private education sectors.

Shocks such as this one have interacted with other concerns – market and corporate governance issues, concerns about the rule of law, geopolitical tension with the US and Russia’s invasion of Ukraine – to create market turbulence.

So there are clearly risks when investing in China, as there would be in any market. We need to assess those risks and judge whether they’re still worth taking.

Long-term impact by asset class

Measures to deleverage the property sector and to stop financial technology firms from engaging in regulatory arbitrage – evading the stricter rules that govern financial institutions – should reduce risks in the medium-to-long term.

However, these actions are also a reminder that sudden shifts in regulatory boundaries could imply higher risk premia in markets, higher hurdle rates for firms’ investments and, more generally, increased market sensitivity towards perceptions of the authorities’ goals.

We’ve analysed the data and here’s our latest thinking across equities, sovereign and corporate bonds:

Offshore equity. Lower prices reflect a fair amount of regulatory uncertainty given that some 40%–50% of the MSCI China Index is directly exposed to regulatory actions (i.e. internet, education and real estate). An additional discount is likely to be a result of renewed headwinds this year, such as spill-over risk from sanctions on Russia and economic disruption from China’s zero-Covid policy.

There’s at least a 25% upside for rerating should these macro headwinds recede. Once earnings expectations stabilise and the impact of regulation can be quantified by bottom-up analysis, investors may find current valuations attractive.

Onshore equity. Valuations have been less affected because the internet, education and real estate sectors only represent some 3% of the CSI 300 Index. More importantly, domestic investors don’t think current regulatory change will impair prices in the long run.

This remains our preferred asset class to tap into China’s long-term growth story. However, investors will need to pay close attention to the impact of regulatory change on corporate profitability.

Sovereign bonds. Chinese government bond (CGB) risk remains modest. In fact, the market has been relatively calm by historical standards. That’s not surprising since this market is driven primarily by fundamental factors – fiscal health, financial stability, external balance and easing monetary policy. A sovereign default seems very unlikely, even if the property sector suffers a hard landing. CGBs can offer an attractive diversification option, especially with the central bank’s relative independence.

Corporate bonds. Badly affected by regulatory change – property developers are big issuers and poor sentiment around the sector has spread to other issuers, regardless of quality. However, given our assessment that troubled developer, China Evergrande, won’t be a ‘Lehman moment’, we don’t think current bond yield spreads represent a ‘new normal’.

In fact, we think corporate bonds represent an opportunity for active investors who can exercise careful credit selection and time the market to profit from this aberration