China In Decline? Hardly, Malkiel & Ahern Say

June 18, 2015


Chinese equities have been staging an impressive rally recently. What’s driving that? Is it hinged on ideas of QE?
Ahern: It all starts with the reform-minded leadership that was appointed two years ago. In our view, it has “walked the walk” and “talked the talk.” The leaders are implementing a reform agenda that helps the economy and the society, and that’s being recognized. They want state-owned enterprises to be more efficient; they’re allowing private investors in; they’re spinning off noncore businesses; there’s been a lot of M&A activity.
The onshore Chinese market was the best-performing stock market globally in the past year, up something like 90%, and that’s mainly “consumed” by investors in China because foreigners have limited access. That tells us that Chinese investors have recognized how the reform agenda can benefit the stock market, but you also have to consider that they don’t have that many other investment options.
They could invest in a money market fund, but that yields about 5% in China. They could put money into housing, but prices have flattened out. They could put it into wealth management products, but those don’t look as guaranteed as they were in the past, or they could put it into gold, but that’s done poorly.
Ultimately, the momentum in the onshore market is driven by Chinese investors who recognize the reform agenda and find that the stock market looks good relative to other investment alternatives.
What are some of the specific opportunities you see? The mainland A-shares market outperformed the Hong Kong market by some 40 percentage points in 2014. This year, H-shares are catching up. Is the disparity between these markets to be expected, and does it represent some sort of arbitrage opportunity?
Ahern: The big picture is that the onshore market represents what the Chinese think of their economy. The Hong Kong market and U.S.-listed Chinese companies represent more what foreigners think about China.
This huge disparity between what Chinese and foreigners think is impressive, but what’s driving the H-Shares market recently is the “southbound” expansion of Stock Connect. Investors in China recognize that dually listed stocks are trading at a 20-plus % premium in the mainland market. You can own that same company at a discount in H-Shares.
Short selling is not allowed in China, so arbitrage opportunity is limited. That said, the spillover into Hong Kong is mostly due to southbound traffic, but sentiment is changing around China. GDP is growing at 7%, off of a base that’s the second-largest in the world.

GDP growth in China alone is equivalent to three Singapore GDPs combined. Growth has to be looked at in perspective. It’s a massive economy that’s growing at 7%—that’s the envy of any country globally. That sentiment change among foreign investors is being reflected in Hong Kong.

U.S.-listed Chinese names have been the real laggards. They are some of the best names in China—Alibaba, Baidu, etc.—and arguably, some of the best-managed companies and best-positioned companies in an economy that has a growing drive to raise consumption and depend less on exports. These stocks still have to catch up.
So should U.S. investors own vehicles that include all types of China shares, or focus on the value opportunity in U.S.-listed shares relative to A-shares? 
Ahern: Most people don’t break out single countries. They own China through broader emerging market ETFs. This is self-serving, but the only emerging market ETF today that includes U.S.-listed and A-shares is the KraneShares FTSE Emerging Markets Plus ETF (KEMP) [launched in February 2015]. But in my view, KEMP is what the Vanguard FTSE Emerging Markets ETF (VWO | C-85) and the iShares MSCI Emerging Markets ETF (EEM | B-97) will look like in the future. 
Navigating the different share classes and different exchanges can be confusing, and some people are not going to want to do that. The definition of China has been the Hong Kong market. Starting in November, it should include U.S. names, and in June, MSCI should announce its plans for inclusion of the onshore market as well. This is what emerging market exposure will look like in the future.
—Cinthia Murphy  


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