By Greg Kuhnert, Portfolio Manager, Wilfred Wee, Portfolio Manager, Michael Power, Strategist
Chinese New Year is set to arrive on 16 February 2018, leaving behind the Year of the Rooster and ushering in the Year of the Dog. What are the key themes to look out for in the coming canine-related year?
Markets not dogged
In Western investing terms, calling a stock or asset a ‘dog’, usually means it is a poor investment
But things are a little different in China. Indeed, it is still popular to name dogs Wàng Cái, which means ‘prosperous wealth’ and comes from how barking sounds are represented in Chinese: wàng wàng. We think this could be prophetic for the upcoming canine-related year in Chinese assets, although as always, risks remain.
Below are five themes that we believe investors can look forward to:
- Growing Chinese leadership on the environment
- China’s emergence as a technology superpower
- Liberalisation of China’s capital markets
- The renminbi growing as a reserve currency
- Debt growth continuing to slow
1. China’s growing environmental leadership
In Chinese astrology, each year also has one of the five Chinese elements assigned to it: wood, fire, earth, metal and water. Earth is the third element in the cycle and this time around, the Year of the Dog is matched with the Earth element. Earth balances yin and yang, and its energy is stabilising and conserving. It’s apt then that the Year of the Earth Dog that begins on 16 February, could see accelerating progress on environmental issues in China.
When President-elect Trump was threatening to withdraw from the Paris climate accord, President Xi Jinping spoke at the World Economic Forum, in Davos, Switzerland, a first for a paramount Chinese leader. Xi reiterated his support for the Paris climate deal. China is stepping up to fill gaps left by what appears to be an increasingly isolationist American policy.
China is already the world leader in solar panel manufacturing and installed wind power production. Four of the world’s top eight battery manufacturing companies are Chinese. We think of renewable energy as the fourth industrial revolution.
In September 2017 we joined the Asian Corporate Governance Associations (ACGA) delegation to China (Beijing, Shanghai and Shenzhen). We met with Chinese regulators and stock exchanges, domestic institutional investors, listed companies, business associations, and corporate governance experts. We learned that there is a live governance debate ongoing in China and we expect some positive change, if slowly. Certainly, stock exchanges are evolving their approach to governance. We sensed a real elevation in thinking by the Shenzhen stock exchange. The strongest policy efforts can be seen around environmental issues, including for example the green finance agenda and the Five Year Plan for Economic and Social Development. These reforms are already seeing results. The Air Quality Index in Beijing, which seasonally spikes in the winter months, has remained very contained this winter.
Figure 1: Air quality measures are seeing results
Source: Air Quality Index, 01.02.18
2. The emergence of a technology superpower
Each Chinese year is also associated with either yin or yang. This Year of the Dog is yang, which means positive and active. Nowhere is this more reflected than in the seeming frenetic activity China’s emergence as a tech superpower.
E-commerce in China is roughly double that of the US, with China being by far the biggest global market. Mobile payments in China are 11 times that of the US (US$790 billion versus US$74 billion in 2016). Meituan Dianping is the world’s largest online-to-offline (O2O) platform, which in 2016 sold US$35 billion of services (such as restaurant and cinema bookings, and food delivery) to over 200 million customers. Didi Chuxing (China’s Uber) is actually five to six times the size of Uber in its own domestic market of the US, given the huge size of the Chinese domestic market.
A major beneficiary of this change has been China’s venture capital industry, which has grown from US$12 billion in 2011-13 to US$77 billion in 2014-16. China is now one of the biggest global funders of venture capital investment across a wide range of technologies, second only to the US in most cases. There are now 2,500 tech incubators in China. China’s venture capital investment has grown 10-fold since 2013 and, from being an irrelevance versus the US, is now roughly half that of the US.
Figure 2: China’s venture capital industry is growing quickly
Source: McKinsey Global Institute, 2016
3. Incremental liberalisation of China’s capital markets
The ‘yang’ aspect of the coming year also references the ‘sunny’ side of the yin/yang duality, and certainly we expect more sunlight to shine into the previously closed corners of Chinese asset markets.
On 20 June 2017, MSCI announced that, with effect from June 2018, 222 large-cap Chinese A-shares will be included in the MSCI Emerging Market and ACWI indices through a two-stage process. This represents a milestone in the evolution of China’s domestic equity capital markets, the second largest in the world by market capitalisation. It also reflects the significant progress by the Chinese authorities in the opening up of its markets to foreign investors, especially through the Hong Kong and Shanghai/ Shenzhen Connect schemes.
This event could easily be dismissed in the short term as the initial impact on indices is likely to be small due to MSCI’s phased approach to inclusion. China A-shares will represent just 0.73% of the MSCI Emerging Markets Index in 2018, for example, due to MSCI’s partial inclusion factor of 5%.
As China’s domestic equity market opens up more to foreign institutional investors and MSCI raises its inclusion factor for the A-share market, foreigners will become a larger participant in the A-share market. As a result, we expect correlations with other global equity markets to increase. However, we think this will take a long time, and hence investors who access the opportunity early will enjoy these lower correlations.
A similar dynamic is at play in Chinese debt markets. With the third largest government bond issuer in the world, liberalisation has been ongoing for some time. Yet foreign ownership stands, at the time of writing, at under 3%.
The liberalisation of China’s bond market is clearly a priority for Chinese authorities, with access being gradually increased over the last few years. All these reforms work towards the same goal of promoting international investment in China’s onshore capital markets. Many bond index providers have begun to include more Chinese bond assets in their indices, or put investors on notice that they are considering it.
Despite the reforms, full index inclusion is still a little way off due to a mix of complications. The most immediate and noticeable impact of including China in key bond indices would be inflows of capital by international benchmarked bond managers. If nothing else, passively managed institutional money that tracks these indices will be required to buy onshore Chinese bonds. If we then include actively managed strategies, the level of inward investment could grow exponentially.
While uncertain that full inclusion will happen during the year of the dog, Chinese authorities are working hard to liberalise debt as well as equity markets. Yet another key trend that bears keeping an eye on over the coming year.
Figure 3: Domestic Government Debt Security issuance (USD trillion)
Source: Bank for International Settlements (BIS), September 2016. The last year only includes issuance data up until the third quarter.
4. The emergence of the renminbi as a reserve currency
The dog is considered a reliable, hardworking and trustworthy partner. Chinese currency is beginning to reflect these attributes as its importance grows on the international stage.
On 15 January, the German central bank announced that it would include the Chinese currency in its basket of reserve currencies. This followed on the heels of the European Central Bank switching 500 million euros worth of its US dollar reserves into yuan. It wasn’t that long ago, September 2016 in fact, that the Chinese currency joined the International Monetary Fund’s (IMF) Special Drawing Rights basket of currencies, going from 0% to over 10% of the IMF total.
This reflects the importance of China as a global trade powerhouse, as well as the hard work that is ongoing in China to repair its reputation and become a major world currency.
Although we don’t see China displacing the greenback as the world’s reserve currency anytime soon, the effect of incremental increases in reserve holdings could continue to boost the currency’s value, with knock on effects for other areas of the economy. We believe that foreign exchange holdings in Chinese Renminbi is likely to rise this year as a percentage of the total allocated from its current low of 1.12%.
Figure 4: Foreign exchange holdings in Chinese RMB set to rise?
Source: IMF, Bloomberg, 01.02.18. The last year only includes issuance data up until the third quarter.
5. Chinese debt growth slows
A key trait of the dog’s personality in Chinese astrology is that despite how they act, they are worried and anxious inside, as anyone who has ever owned a dog knows!
The Year of the Dog is likewise not without its anxiety in the form of the Chinese debt mountain. But like the loyal and hardworking zodiac dog, the Chinese debt situation won’t be stopped.
Asset markets are priced off three variables: the ‘absolute’, the ‘change’ and the ‘rate of change’. Regarding Chinese debt levels, the first two are clearly negatives for Chinese asset valuations. The level of debt (the ‘absolute’) in China is absolutely high, and it continues to grow (the ‘change’).
However, the rate of increase (i.e. the ‘rate of change’) is clearly slowing. In other words, ‘the rate of change’ is now turning positive. This is an important trigger for the market to become less fearful for China’s economy, with reduced fear potentially providing asset valuation support. In the year of the dog, investors should be looking for signs that this rate of growth continues to slow.
Figure 5: The rate of growth in debt is slowing
Source: CEIC, Wind, UBS estimates, June 2017
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