Gaining exposure to Chinese equity markets

Chinese equity markets have significantly underperformed developed markets like the S&P 500 and Nikkei 225 for a number of years.

Fears around over-leverage in the corporate sector, a bubble in China’s property market, volatility in its money markets and defaults in certain wealth management products have seen investors and traders shying away from buying equities. But is this beginning to change, and how do traders and investors outside of mainland China take advantage of any subsequent rally?

Gaining exposure to China’s markets

Given the closed capital accounts in China, gaining exposure to stocks and indices which trade on the Shanghai or Shenzhen Exchanges is near impossible for non-residents. This puts the two most quoted Chinese markets, the Shanghai Composite and CSI 300 index, firmly off limits.

IG offers three key markets that allow clients to gain exposure to Chinese equities, as well as offering USD/CNY (priced off the one-month non deliverable forward) for currency-focused traders.

China A50 index (cash and futures contracts)

The A50 index is a market-capitalisation weighted index and represents the largest 50 mainland companies; however the futures market trades on the Singapore Exchange. IG quotes this index 24 hours a day to clients, so even when the futures market is shut, IG still provide a price. This is based on a model which takes into consideration moves in other global indices, as well as supply and demand. This index currently has a 97% 30-day correlation with the Shanghai Composite and is naturally a convenient t way to access the Chinese market.

China H-Shares index (cash and future)

The China H-Share index represents 40 of the biggest Chinese companies; however the futures trade on the Hong Kong Futures Exchange. The 30-day correlation between the H-share index and the Shanghai Composite is currently 57%, which is still extremely high when you consider the  S&P 500 and  ASX 200 have an 11% and 30% correlation respectively. IG also offers this index as a CFD to clients 24 hours a day.

Hang Seng index (cash and future)

The Hang Seng is a mix of Chinese and Hong Kong companies, where the futures trade on the Hong Kong Futures Exchange. The current 30-day correlation with the Shanghai Composite is 40% (although this has fallen from 80% in November), so while the index has a keen eye on the Shanghai Exchange, it still has a strong interest in trends in developed markets. The Hong Kong HS50 index  remains one of the most popular indices among our Asian client base.

USD/CNY (one-month NDF)

IG has offered this product to clients for over a year now, and it has been well received. Given the restrictions around getting money in and out of China, a client’s profit and loss is denominated in USDs, rather than the second-named currency. If traders feel the CNY will continue to strengthen in 2014, this is another way to gain exposure to China.

Other options

Considering many feel the  AUD is one of the best and most liquid ways to trade sentiment around China, it is certainly a terrible proxy of Chinese equities, with AUD/USD actually having an inverse correlation with the Shanghai Composite. Also, some fund managers have traded Fortescue Metals Group (FMG) in the past as a play on the China story. However, it’s important to note this is based on the view around its economy, rather than stock market, given that FMG trades inversely to the Chinese market.

The A50, H-share and Hong Kong HS50  index are a convenient way for non-residents to gain  exposure to the China market and if we do see more positive price action in China, these markets should get more attention.

Is it time for Chinese equities to shine?

While many developed markets have seen strong price-to-earnings ratio (P/E) expansion, the P/E and price-to-book-ratio on the Shanghai Composite, CSI 300 H-shares, A50 and Hang Seng have never been lower. In fact, these valuations are over one standard deviation from the long-running average. Investors need clarity around future earnings, and without that the natural buyers of the market, and stocks fall. But have investors got it wrong?

If we look at the valuation on the China A50, the index trades on a consensus earnings of 6.3x forward earnings, which is unbelievably cheap when you consider the market expects EPS and free cash growth of 11%. Bear in mind the ASX 200 trades on a forward P/E of 13.5.

The H-share index trades on a forward P/E of 7.4x and if earnings are correct it has a very strong growth profile. Financials are expected to see solid EPS growth of 8% this year and 11% next year, while also having a very compelling 6% yield. So clearly from a valuation perspective these markets are even cheaper than many emerging markets; they are tightening policy significantly to lower inflation.

JP Morgan wrote a report this week that they believe a 15-20% rally could be seen in the Chinese market in the coming weeks. They put this down to historically low valuations as well as seasonality factors, with the official manufacturing PMI series having the best performance on average in the months of March and April. They also see the upcoming meetings from the NPC and CPPCC in March as positive catalysts, with the market focusing more on structural reforms.

Deutsche bank has reiterated its stance that China is likely to record GDP growth above 8% this year, which has to be good for the domestic banks and should have a sizeable weight on these indices. European growth is still only expected to see improved growth of around 1% this year and  China and Europe have huge two-way trade. However if the US is expected to grow around 3% then Chinese companies with greater exposure to cyclicality could also do well.

There are significant risks this year and these markets may well prove to be a value trap, however if we do see a strong rally emerge in the coming weeks it’s important to remember that Australian traders do have access to Chinese markets, by way of CFDs on the indices referred to above.

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