[This article originally appeared in our June issue of ETF Report
With China’s economy slowing, but its stock market continuing to outperform global markets, advisors and investors can have a difficult time assessing what the right approach is that should be taken with the country. We asked two experts on China for their thoughts on the country going forward: Burton Malkiel, the Princeton economics professor who first published the index investing classic “A Random Walk Down Wall Street,” his 1973 book, is also chief investment officer for Wealthfront; and Brendan Ahern is CEO of ETF issuer KraneShares, which has several funds covering different aspects of the Chinese market.
What are some of your thoughts on China as a place to invest?
Malkiel: First of all, there’s an enormous amount of negativity about China. I think the New York Times seems to have a negative story about China every other day on the front page. There is just an enormous amount of negativity.
China is slowing down. But I must say I find it very peculiar to read stuff that says “Oh my god, China is crashing and burning because it’s growing only at 7% rather than the 10% that it used to grow at.” It can’t sustain a 10% growth rate; it’s too big. It won’t be able to sustain a 7% growth rate because it’s bigger and bigger. But China will continue to be the highest-growth-rate large economy in the world. Growth will continue to decline, but China will continue to grow. I wish China could sustain a 4-5% rate of growth, which I think China will sustain for at least another decade, if not more.
China’s growth is slowing dramatically. But it’s still higher than any other place in the world. Does China have problems? Sure, it has problems. It’s had a real estate bubble. China’s slowing that down. It’s one of the reasons the stock market’s doing better, because the government is deliberately trying to put a lid on the increases in real estate prices.
So, macro: Much too much negativity. China’s got problems. Growth is slowing. But it’s still going to be very good.
Are the tight business and investment rules and regulations of the country hurting growth?
Malkiel: On the micro side, you’re absolutely right. It’s had Byzantine regulations. From my standpoint, it’s much too slow in relaxing them. This opening of the A-share market has now been talked about for two years, and it’s only just really starting to happen now. So it’s much slower than I would like. But it’s happening.
China, as now the second-largest economy in the world, will eventually relax more and more of its foreign exchange controls. China would love to be a reserve currency. China can’t be a reserve currency with the plethora of controls that it’s got. It recognizes that. And it’s eventually going to feel strong enough to relax the controls even more. It won’t happen nearly as fast as I would like to see it happen, but it’s inexorably going to happen. And I’m still a long-run bull on China.
The sliver of A-shares participation is really a sliver; barely 1% of market capitalization is allocated for foreign investors. Is there a level you think it might be realistic to expect over the arc of time? Where would it be realistically?
Malkiel: Let’s look at it in the following way: All these numbers are a little bit fudge-y because it depends on how you do purchasing power parity adjustments. But if you take some IMF-type figures, China’s maybe 13% of the global economy. You can argue with me it’s not 13%, it’s 14%, and you can argue it’s 11%. But it’s certainly more than 10% of the world economy now.
I believe China is going to be the fastest-growing economy in the world over the next decade. When you look at the valuations of Chinese stocks—I like to use the Shiller CAPE—Chinese stocks are much cheaper than U.S. stocks, much cheaper than stocks in other parts of the world.
So let me ask you: Why would it be unreasonable to think that eventually when people get over their home-country biases that people are going to want a GDP weight for China?
Bill Bernstein says, “Well, I’ll make peace with China in a globally allocated equity index fund. But do I want to seek alpha in a place that doesn’t even protect its children, with all kinds of volatile organic compounds spilling out of their plastic toys or baby formula? I think not.” That’s sort of in some ways a very hyperbolic riposte to your question, but I think one that needs to be at least considered.
Malkiel: Let’s say China is 14% of the world economy; I would take his comments and say: “Look, China’s very volatile and risky, and it’s still a dictatorship. They’ve got big pollution problems. They’re working on all of these. It’s not that these things aren’t recognized. These kinds of environmental concerns have always accompanied emerging markets. China’s made some progress. It’ll continue to make some progress.”
There’s plenty of room in the middle to accept some of the things that a Bill Bernstein might say and still think, “We really ought to look at our allocations. China’s very underweighted.”
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?
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.