Chinese stocks were left for dead in 2018.
But this year, they’re the best performing in the world, rising 23 percent since January 1.
You can see this in the chart below.
That’s the best two-month start for Chinese stocks ever.
There are several reasons behind this record-breaking rally.
One is valuation. After a major selloff like the one we saw last year, during which Chinese shares fell by 25 percent, valuations became compelling (investors are always paying attention to valuation). These kinds of valuation levels have historically signaled a turnaround in the market.
Second is sentiment. Last year was full of gloom, with the U.S.-China trade war threatening to throw China’s economy completely off the tracks.
But that sentiment has changed for the better since U.S. President Donald Trump extended the March 1 deadline for reaching a trade deal. There’s also an increasing likelihood that a deal will be reached to kick the can down the road.
Now, we have another reason for China’s stock market to continue to do well throughout 2019.
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China’s increasing influence in global indexes
MSCI (which stands for Morgan Stanley Capital International) is one of the top providers of indices for emerging markets, of which China is one. These indices are tracked by fund and investment companies to help them build emerging market portfolios.
Back in June 2018, MSCI added A-Shares to its Emerging Markets Index for the first time.
Inclusion in an index managed by the MSCI has enormous implications, because trillions of dollars of managed funds track these indexes.
For instance, if you own an emerging markets unit trust or investment fund, chances are good that it uses the MSCI Emerging Markets Index as a benchmark. Most actively-managed funds pretty much just copy the index (by investing in the companies that form part of the index) without admitting it.
Other investment products, like exchange traded funds (ETFs) or index funds, are designed to copy the index exactly.
So when MSCI makes a change to an index, trillions of dollars’ worth of investment funds copy what they do. That means that billions of dollars’ worth of stocks are bought and sold based on the decisions MSCI makes about its indices. That’s enough money to have a major effect on a share’s, or market’s, price.
For the Emerging Markets Index alone, an estimated US$1.9 trillion of assets managed by various funds are benchmarked to it.
That initial inclusion in June was largely symbolic, as only 0.72 percent of the entire index was comprised of A-Shares. However, we said that this move would eventually pave the way for a higher allocation of A-Shares into the popularly-tracked MSCI index.
That’s starting to happen.
Last week, the MSCI announced that it would more than quadruple the weighting of Chinese-listed A-Shares on its important and highly-followed MSCI Emerging Markets Index.
From just 0.72 percent currently, the composition of A-Shares in the index is going to increase gradually in three phases until it reaches 3.3 percent of the index by November 2019. Relative to the size and importance of China’s stock markets, that’s small. But it’s a big step.
On completion of this three-phase implementation, there will be 253 large and 168 mid- cap China A-Shares, including 27 ChiNext shares (a NASDAQ-like board on the Shenzhen Stock Exchange intended for technology stocks), in the MSCI Emerging Markets Index. That’s a total of 448 A-Shares.
That’s up from less than 230 A-Shares before the latest increase.
A-shares are shares of Chinese companies that are only listed in either of China’s two stock exchanges (Shanghai and Shenzhen).
They are only available to domestic investors and through a limited cross-border investment programme with Hong Kong, called the Shanghai-Hong Kong Stock Connect Scheme and Shenzhen-Hong Kong Stock Connect Scheme.
Foreign investors are currently allowed to trade a maximum of 52 billion yuan (US$7.6 billion) worth of A-Shares in each exchange (Shanghai and Shenzhen) daily.
But prior to the latest MSCI announcement, less than half of that daily trading quota was being used, even taking the strong performance of China’s stock market into account.
That’s starting to change.
As you can see from the chart below, the average daily value of A-Shares being traded through the two Stock Connect Schemes significantly increased in February.
And trading value on these Stock Connect Schemes has continued to surge this month.
The total value of A-Shares being traded via the Hong Kong-Shenzhen Stock Connect Scheme reached 21.2 billion yuan on March 1. For Shanghai, the total value traded was 28.4 billion. Both were significantly higher than their February daily averages.
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125 billion reasons why this is important
The recent hike in A-Shares’ contribution to the MSCI Emerging Markets Index is expected to result in as much as US$125 billion of funds flowing into the 448 selected Chinese-listed stocks.
But because this is going to happen over three phases, don’t expect a sudden flood of money inundating the market, resulting in an A-Shares bubble.
It will be more like a rising tide that gradually lifts Chinese A-Shares, which is more sustainable.
This is good for China-focused funds
MSCI’s latest hike in A-Shares’ inclusion in the Emerging Markets Index brings China one step closer to achieving its goal of being an accepted member of the global stock market club.
While the latest move increases A-Shares contribution by more than four-fold, there’s still plenty of room for China to play a larger role in MSCI’s indexes. That means we’re only seeing the beginning of this rising tide.
As I mentioned earlier, prior to the recent announcement, A-Shares only accounted for 0.72 percent of the MSCI Emerging Market Index. The new weightings bring that up to 3.3 percent.
If the MSCI were to include 100 percent of China’s A-Shares, their weighting in the index would rise to 16.2 percent.
However, a full weighting of all A-Shares is unlikely to happen very soon. China first needs to further develop and open its financial markets.
Global investors still view China’s stock markets as generally risky. Currency controls, for instance, increase the risk that investors may not be able to get their investment out in case of a sudden decline in the markets.
And there’s still a lack of risk-management tools available to foreign investors, such as index futures and other derivatives on China’s A-Shares market.
China’s stock market is also still dominated by individual investors who make up 80 percent of daily turnover. These investors are easily swayed by news, rumours and speculation rather than longer-term fundamentals, which increase volatility in the markets.
The key takeaway here is that mainland Chinese stocks are increasing their influence in global indices. It’s becoming too big to ignore, and investors who get in early will reap the biggest rewards.
How to profit
The easiest way to invest in China’s A-Shares is via ETFs.
A very popular one that trades on the Hong Kong exchange is the iShares FTSE A50 China Index (Exchange: Hong Kong; ticker: 2823). This tracks the performance of 50 of the largest Chinese companies that trade on the Shanghai or Shenzhen exchanges. The ETF doesn’t own the shares, but it uses derivatives to mimic how those shares perform. It’s currently up 26 percent year-to-date.
Singapore has the United SSE50 China ETF (Exchange: Singapore; ticker: JK8), which also tracks 50 of the largest China A-shares. It’s currently up 25 percent since the start of the year. The trading volume for it is quite low, so be careful when you buy and sell.
If you would like to buy China A-shares in the U.S., included above are two of the largest funds. But these (like the iShares China Large Cap UCITS and the Morgan Stanley China A-Share Fund) have low trading volumes too, so careful trading them.
Editor, Stansberry Pacific Research