Peter's Perspective
14th June 2016 by Peter Churchouse

Is China In? Or Out?

Tama wrote a short Peter’s Perspective piece last week in which he talked about a simple idea to ‘beat’ the S&P 500 index (“Beating the S&P 500… Revisited”)

An interesting statistic he cited was that there are US$7.8 trillion dollars ‘benchmarked’ against that particular equity index.

Now, given the trillions of dollars invested against this index, any changes to the composition of the index can clearly have a big impact on the share price of specific companies included (or excluded).

If a new company is being added, then there’s a LOT of money (both passive and active) that can potentially flow into that stock.

In reality though, especially for the bigger indices, you find that newer participants typically constitute only a tiny proportion of the index… therefore, their price impact on the overall index will be small.

Why? Because most larger indices weight their constituent companies by market cap, which means most new additions enter at the bottom.

As a result, these stocks are much less important (to active investors in particular).

Take a company like Urban Outfitters (URBN US) for example. Yes, it’s an S&P 500 company.

But its weighting is less than 0.015% in the index.
On the other hand, Apple’s (AAPL US) weighting is over 220 times that.

So, as an investment manager benchmarked against the S&P 500, the decision you make on being underweight, neutral or overweight Apple is much more important than your view on Urban Outfitters!

Ultimately, companies can fall into a big index and fall out of it without much fanfare because they’re just not that relevant to overall index performance.

But what happens when the equity market of an entire country is suddenly added to a major equity index?

That’s what we’re looking at this week.

MCSI, one of the world’s most followed providers of equity indices is set to make a decision on whether or not to include China’s “A” share market in its Emerging Markets indices.

We should have their decision some time tomorrow.

You need to be aware of how this event can affect you and your investments, in the short term, and in the medium to longer term.

This event has the ability to substantially to re-shape the global equity scene, not just in the immediate aftermath of June 14th, but also over a much longer period.

For a market to be included in a widely followed index can be a big deal.

It means that most major investors or ETFs whose funds track that index will probably deem it necessary to add that stock or country to its portfolio. They will HAVE to be invested there.

This can result in a flurry of initial buying activity. And of course, to make room for the newly included positions, other positions need to be sold.

MSCI is one of the world’s largest providers of indices. It has hundreds of different indices and more than US$10 trillion of funds managed assets are benchmarked against its various indices.

Some 95% of U.S. pension fund assets in global equities are benchmarked to MSCI indices.

Of the US$10 trillion benchmarked against MSCI indices, some US$1.5 trillion is allocated to emerging markets.

China’s stock market is by far the largest in the emerging markets universe in terms of total market capitalisation. It is going to become one of the largest stock markets in the world in the coming few years.

But China’s “A” shares, traded on the Shanghai and Shenzhen stock exchanges, are not included in the MSCI Emerging Markets Index (or most other global indices).

However, China companies do represent some 23.6% of this index.

These are either “H” shares – Chinese companies listed in Hong Kong – or shares of Chinese companies listed in say the U.S. – for example Alibaba Group Holdings.

These make up a big part of the top twenty companies in this index.

Inclusion of “A” shares that are listed in China itself could lift the China portion of the MSCI Emerging Markets Index to around 39% from its existing 23.6%.

A full and immediate inclusion would mean hundreds of billions of dollars pouring into China’s stock market.

So should we all just pile into “A” shares ahead of a big buying spree?

No.

Much has been made of MSCI inclusion in the past. China’s security market regulators are keen, almost desperate, for China’s “A” shares to be included.

Inclusion puts a global stamp of approval on their market and their regime. But it also could help force China’s regulators and companies to adopt more internationally accepted standards and norms.

On two earlier occasions MSCI postponed adding “A” shares to its indices.

On each occasion the prospect of inclusion sent shares scooting higher in anticipation of big foreign flows into the markets.

It did not happen. And for very sound reasons.

MSCI judged, rightly in my view, that the regulatory environment in China did not justify inclusion of these markets.

So what are the sticking points?

First it is about access. China has limited access for foreign investors to its markets by imposing a series of quotas and daily trading limits. It has imposed a maximum aggregate amount that can be invested through its Hong Kong – Shanghai Connect program.

Its various other schemes do not allow easy or free access for all those funds around the world to own China shares.

Access is a lot better than it was a couple of years ago. However, it is still far from an open market for foreign investors.

Second, there have been concerns regarding share ownership rules and protection of investor rights.

New rules recently put in place should provide a greater level of comfort to foreign investors, specifically their right to be recognised as the actual owner within China when they buy through the Connect program is being addressed.

Third, rules on repatriation limits for funds investing in China are an issue. Again, this constrains liquidity and freedom of movement of capital.

Fourth, is the issue of trading halts. This is a big issue. In early July of last year when the China market plunged there were well over 1,000 companies with suspended trading.
This froze roughly 40% of the country’s total market cap!

This can be disastrous for an ETF or any fund manager operating in this market. If large swathes of companies can simply stop trading of their shares on a whim, then investors can be seriously disadvantaged.

They are trapped, held hostage for months.

Changes to the rules for trading halts should ease concerns on this score considerably.

The pundits are saying that China’s securities regulators have done enough to justify inclusion of China “A” shares in the MSCI Emerging Markets Index.

Or at least that the probability of inclusion has risen.

So what is a likely outcome here?

MSCI is a conservative organisation. They do not rush into these kinds of things.

If they do opt for inclusion it will be a small amount. It will not be one big swoop that raises the China component from the existing 23.6% to the full 39%. No way.

More likely in my view is that it will be done in baby steps.

Perhaps by the inclusion of 5% for “A” shares, to take the China weighting to around 28% – 29%. Then step back, and keep watching if regulators continue to gradually address all the concerns that MSCI and overseas investors have.

So what does this mean for the “A” share market?

This time round, not a lot I think. We’ve not seen much ‘front-running’ action by mainland investors anticipating a big buying spree from foreign investors.

And as far as overseas investors are concerned, I suspect the resulting inflows are likely to be tiny in the grand scheme of things.

Some estimates put the total likely net inflows to be around US$15 billion, over the course of a year.

This is less than a day’s-worth of trading volume.

It’s not going to move the dial unless it comes with a surge of domestic speculation.

Yes, there are a good many investors who will see it as necessary to add to China holdings. But many will hold their fire.

Why?

Well, emerging markets are hardly the flavour of the month right now, and the China market is up front and centre stage of the emerging market fear scale.

The concerns are all plain to see. Slower growth in China poses a range of risks both globally, regionally and certainly domestically.

The structural transition of the economy from being investment and export growth driven to more consumer driven is happening for sure.

But the transition is going to take time.

Second is China’s burgeoning debt mountain. The threat of rising non performing loans, defaults, bankruptcies, pressures on banks are very real. It is happening. Now.

Third is the prospects for a sharp devaluation of the renminbi.

Again, there are very real risks here. But now China is part of the global big boy’s club at the IMF. It also has probably the best defensive armoury amongst the larger economies.

There are good reasons to think that a sharp, and rapid devaluation can be avoided. Again, it is not a given, but a crash in the currency isn’t a given either.

Either way, I don’t think MSCI’s partial inclusion of the “A” share market into its indices is a good enough reason to go out and load up on these stocks yet.

Good investing,

Peter

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