China joins the club

It’s been four years in the making but we have finally seen China’s A-shares garner representation in the MSCI Emerging Market (EM) Index. This outcome has been somewhat expected and therefore the reaction we have seen has been far from euphoric, with only modest gains in the China A50 futures and mainland indices like the CSI 300.

China data board
Source: Bloomberg

The significance of the maths involved, with 222 Chinese mainland stocks being included in the MSCI Emerging Market (EM), commanding a 0.73% weighting in the index, is that we should see around $12 billion of net buying in Chinese shares from passive funds that track the MSCI EM index. This buying won’t occur in one go though, and the rebalancing from passive (or tracking) funds will take place in two steps, in May and August 2018. Active funds (who try and outperform an index) may look to buy prior to that period. So considering as we are talking an amount equivalent about one-day A-share turnover, one can understand why no one is getting too carried away on this announcement.

The longer-term prospects for Chinese equities though are quite interesting. Currently, only 5% of A-share listed companies are eligible for representation in the index. However, over time one could expect up to 100% of corporates eligible and this could attract anywhere between $300 billion to $500 billion of passive funds into Chinese mainland stocks over the coming five years or so, and that would largely be conditional on capital controls, allowing greater international market participation.

Other important factors and considerations include the Chinese regulatory bodies working with corporates to smooth out concerns about the sizeable impact when corporate insiders exit holdings, not to mention continued stock suspensions and much needed improvements in corporate governance.

There is no doubt that China’s equity market should play a far greater role in the global financial landscape and make up a significantly larger percentage of the MSCI EM index than the 0.7% weighting. Consider that the A-Shares is not only as it is the second most traded equity market globally, but China’s role in global trade is obvious. So this move from MSCI Inc should be seen as a small, yet strategically highly important step in China’s development on the world stage.

There are great incentives for the Chinese authorities to address the aforementioned concerns and appeal to MSCI Inc. And by having a fully functioning, assessable and liquid equity and bond market not only attracts international capital, which in turn will increase liquidity. But, it gives choice to domestic players and this, in turn, will curb one of the big fears from Chinese authorities – capital outflows.

The trade

IG provide one, if not, the most extensive range of any retail broker on Chinese markets, both onshore (CSI 300) and offshore (A50 futures, Hang Seng and H-Shares). The CSI 300 should be on trader’s radar anyhow, as the index is eyeing a break and close through the 12 June high and subsequently the best levels since December 2015. The combination of trend, momentum and an attractive valuation at 11.6x forward earnings suggest good upside anyhow and being long on Chinese equities, while for traders with a greater tolerance for risk and volatility, looks like a market that should really outperform this year. A move to the December highs of 3745 and into 4000 is not out of the question this year.

 

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