Sizing up a direct allocation to Chinese assets is preferable to market-determined index exposure
Direct investments provide a much stronger tie to China’s underlying economic activities and performance. Given China’s significant global footprint, index investors won’t gain an ‘economically representative’ exposure until China’s weight in key global benchmark indices reaches high double-digits. Not surprisingly then, global investor surveys show that respondents prefer a direct investment in China, as opposed to a benchmark index, because it gives full autonomy over their sector allocations.
Equity investors can get the best rewards from nimble trading and active management
A common misconception is that China is only an attractive investment destination when its GDP growth is strong. We show statistical evidence that there is no relationship between China’s GDP growth rate and its equity market returns – what matters much more is the output gap or business cycle. China’s equity returns have performed well during growth decelerations as long as realised growth is above or close to trend (e.g. over the last 10 years China’s real GDP growth has fallen from 11.5% to 6.1% p.a. yet its equity returns were 5% p.a.).
To achieve the best performance from investing in China, equity investors need to be nimble and focused on fundamentals that are likely to have an impact over the next 1-3 years. The importance of being nimble reinforces the case for active management strategies, and historical performance data shows that active management of Chinese equities can significantly outperform index-based investments.
China provides alpha opportunities, in particular across higher value-added consumer, technology, e-commerce and healthcare sectors. Investing in China A equities also gives some diversification away from Developed Markets, especially over the longer-term.
Bond investors can get solid returns and diversification
Because of higher yields versus Developed Markets, China’s fixed-income should be attractive to investors seeking solid risk-rewards with a desire to diversify away from Developed Markets. China’s fixed-income is also superior to most Emerging Debt Markets because of China’s strong sovereign fundamentals, its low correlations with global markets in general, and the likelihood of a favourable risk-reward balance.
Investors still have to be cautious and selective in the post COVID-19 environment
With the world in the midst of a COVID-19 recession, China seems well-placed to drive the global recovery while the rest of Asia, the US, and Europe, will lag. Very low Developed Market yields driven by Quantitative Easing policies should make China’s bond returns even more attractive. China’s equities may continue to outperform other countries, as we have seen so far this year, as its domestic demand rebounds.
However, the latest deterioration in US-China relations is very concerning and creates significant uncertainties for investors – especially those considering making greater allocations to China or Hong Kong. As a result, investors are likely to pause and wait for more clarity on how US-China relations will unfold.
Looking beyond greater geopolitical risks, as China continues to rebalance its economy, its risk-adjusted equity investment returns should become more appealing to longer-term investors. With the benefit of on-going economic rebalancing, if China’s equity market returns can become less business-cycle/output-gap centric, then longer-term returns can improve and more importantly, volatility can fall.