In this insight, we review the status of Stock Connect. The low daily utilization hides the fact that Stock Connect has reshaped China investing. We look at who's buying what, why, and how much while also exploring where the program is headed.

Jan 17, 2018

A-shares outperformed most developed markets during 2017. In this update, we review the drivers of 2017 performance, the opportunities and challenges in 2018, and the risks we should be mindful of. Our conclusion?China outperformed most DM markets during its mid-2017 onward rallyMega-caps and Consumer Staples outperformed, reflecting investors’ focus on stability and concerns with debt (which we believe are completely overblown)We expect 2018 conditions to support strong equity market returns in ChinaDeleveraging and quality vs growth focus will be balanced and targeted, not destabilizingHealthy earnings growth, a supportive global macro economy and low A-shares valuations are conducive to a positive outlookRetail inflows to equities are likely as investors are pushed to stocks by a crackdown in “alternative” savings productsOur predictions for China A-shares in 2018:A-shares will outperform DM and likely broader EM / offshore China stocksDomestic and foreign inflows into A-shares will be strongMid-small caps will post decent positive returns, likely mean-reverting to outperformance vs large-capsOur favorite themes going forward include consumption upgrade/premiumization, social welfare, electric vehicles, industrial automation and IT backbone infrastructure2017 RecapNow that 2017 is nearly over, we’d like to review the China market over the past 12 months and explore what opportunities and risks await us in 2018. 2017 was characterized by an overall increase in risk appetite for equities since the beginning of the year, with positive sentiment eventually spreading from the US to global markets, particularly EM. China’s A-share market is no exception to this, though its rally lagged by a few months. The long-awaited announcement of A-shares inclusion into MSCI Emerging Markets Index was the catalyst that triggered the strong run from mid-2017 to today. Since then, China A-shares managed to outperform most developed markets, including US, Europe and Japan. Source: Bloomberg as of Dec 11, 2017Go Big or Go HomeWhen looking closer at the A-shares market, the diverging performance among mega-caps, large-caps, mid-caps and small-caps is hard to miss. The former two segments had a decent gain whilst the latter two were either flat or loss-making year-to-date. Source: Bloomberg as of Dec 11, 2017Note: Mega-cap: CSI100 Index, Large-cap: CSI200 Index; Med-cap: CSI500 Index, Small-cap: CSI10000 Index As we have been saying the past 6 months, investors are no longer worried about a potential massive economic slowdown, any one-off depreciation of yuan or uncontrollable capital outflows. This lack of worry explains the positive return recorded among mega-caps and large-caps. On the other hand, some market participants remain cautious as both the International Monetary Fund and local government officials voiced concerns about the Chinese financial system’s vulnerability from high leverage. China’s total debt increased from 164% of GDP a decade ago to today’s 259% of GDP. Economists now estimate the figure may go over 300% by the end of 2020, which may put China in the danger zone for a financial crisis. This limited investors’ all-in risk-taking mindset, resulting in strong security selection bias towards the larger stocks and avoidance of the mid-to-small cap segments so far.Our view differs. We think the debt issue is exaggerated and does not pose any imminent risk. Investors forget that over 60% of the country’s corporate debt belongs to state owned enterprises (SOEs). Government lending to government, left hand to right hand. It is unlikely that the Chinese government would not bail out an SOE if systemic risk issues arose. At the same time, the authorities are pushing SOE reform by developing mixed ownership of SOEs via privatization of state assets and debt-equity swaps, seeking to decrease inefficient leverage in the system. Lastly, investors seem to forget that 259% of GDP is not that big a number when thinking in total debt to GDP terms. The US, for example, is not better. The Federal Reserve estimates that domestic non-financial debt outstanding was $48.6T. GDP is $19.5T. If my math is right, that puts the US at 250% of GDP, and that’s not even considering financial debt. China doesn’t seem that worrisome in comparison. Bread and Butter were the standout sector in 2017From a sector point of view, Consumer Staples led the market by a large margin, recording a gain of 75.2% year-to-date. Three new economy-focused sectors, such as Information Technology, Consumer Discretionary, and Healthcare, performed in-line with the market whilst Utilities, Energy and Industrials underperformed. Traditional economy underperformance is not surprising given the rebalancing of China’s economy toward services. The surprise was Consumer Staples’ place atop the leaderboard, likely driven by a policy focus that emphasized “Financial Stability” over “Financial Innovation” throughout the year, forcing investors to prioritize Consumer Staples over new economy sectors. Source: Bloomberg as of Dec 11, 2017 2018: Full Steam AheadLooking ahead to 2018, we expect most of the positive factors to still be in place for China over the next 12 months. Externally, the global economy has continued its steady recovery, providing a solid foundation for equities. The absence of a GDP target indicates China is shifting from high growth to high quality development, with priorities being given to controlling systemic risk, narrowing the gap between the rich and the poor, promoting regional development, fighting against corruption and protecting the environment. Despite this quality over growth focus, China’s economy will expand by 6.8% in 2017 and 6.4% in 2018 based on consensus data. The growth rate is 3x that of DM, behind only India among the major economies globally (though off a much higher base than India!). Source: Bloomberg, Consensus forecast, as of Dec 11, 2017 Since bottoming out in mid-2015, China’s industrial enterprise profit continued to rise and reached the highest level in 7 years, underscoring resilience in the economy as authorities intensify their efforts to cut excess capacity and reduce pollution. This gives the government plenty of room to focus on over-supply and deleveraging, while balancing those long-term goals vs short-term pain. Robust producer-price inflation, improving output and consumer spending have been supporting the expansion and will likely keep it on track. It is expected the momentum will carry on in 2018, although the pace of growth may slow down slightly. Source: Bloomberg, National Bureau of Statistics of China, as of Dec 11, 2017 Reasonable Valuations and Healthy GrowthOn corporate earnings front, things look encouraging with earnings growth of 14.8% expected for the year of 2018 versus 10.0% in the US, 12.4% in Japan, and 6.5% in the UK. At a sector level, all China sectors are expected to achieve at least double-digit growth rates, although financials will be the slowest one. Banks’ profit has been in a plateau since 2014 and is unlikely to move materially over the next 12 months. Source: Bloomberg, as of Dec 11, 2017Note: Sectors: GICS classification; China A: CSI300 Index Overall valuations are relatively attractive as forward P/E is only 13.5x versus mid-to-high teens for major developed and emerging equities markets globally like the US, Japan, and India. It is not out of the question that we see an upward re-rating of China A-shares given this healthy growth profile. Source: Bloomberg, as of Dec 11, 2017 Lastly, the forward free cash flow yield spread between equities and the 10-year government bond yield remains historically high. The last few years have been characterized by bond market inflows and equity market outflows, not just globally but in China as well. The yield advantage of equities may justify a reversal of this trend, driving inflows into equities and making A-shares a very promising exposure for 2018. China’s authorities have been cracking down on “alternative” investment opportunities for retail investors, making A-shares a logical destination going forward. As an example, wealth management product sales are slowing as regulations are tightened. The government earlier cracked down on insurers that were selling wealth management products with guaranteed returns, on concern that their funds were channeled into war chests that funded aggressive acquisition and speculation. Several insurers already had their licenses revoked, or closed. Similarly, financial institutions were ordered to stop promising returns on their products, based on a set of preliminary regulations drafted a month ago by five Chinese regulators overseeing securities, banking, insurance, foreign exchange and the central bank. Traditional equity returns have been good, the number of brokerage accounts is increasing, and retail investors are likely to funnel money into equities in the absence of other alternatives. Source: Bloomberg, Jefferies, as of Dec 11, 2017 Our thoughts for 2018We would like to make a few predictions for the year of 2018: (1) China A-share will continue to outperform developed markets on solid macro environment and earnings momentum; (2) There will be actual domestic and foreign inflows into equities market, reversing the net outflows in the past couple of years since A-share peaked out in mid-2015; (3) Mid-and-small-caps will record a decent positive return if not outright outperforming large-caps on low valuation and mean reversion. Size is a particularly interesting factor to consider. The gap between mid-small caps and large cap performance is at global financial crisis levels. On a 1Y and 3Y rolling basis, mid-small caps typically outperform large-caps by 5% and 25% respectively. Yet today, those gaps stand at -20% and -29%. We believe there is a high probability of mean reversion in mid-small cap vs large cap performance. Mid-small cap is where much of the growth is coming from, and with SOE reform and potentially deleveraging, it is the inefficient large-caps that are likely to pull back relative to private sector mid-small caps. Source: Bloomberg, as of Dec 11, 2017 Themes to watchStocks and sectors with exposure to the following themes are likely to be a focus for investors in 2018:Consumption upgrade/premiumization: middle class growth and improving lifestyle may require higher quality consumption, which is likely to benefit branded consumer items in both discretionary and staples sectorsSocial welfare: government intention to improve the safety network whilst increasing household income is likely to drive demand for insurance products and public/private medical servicesElectric vehicles: the regulator will force automakers to increase production of their own electric vehicles. It may help generate substantial demand for upstream products, such as battery materials, including lithium and cobalt Industrial automation: higher labor costs are becoming a concern among manufacturers in the past few years. Factories will grow capex to automate their production lines using roboticsIT backbone infrastructure: the backbone infrastructure will need to be improved to facilitate increasing internet traffic, inducing good order flows in optical network and communications equipmentRisks on the horizonTo be sure, we do not view the world through rose-tinted glasses. The risks are manageable, in our opinion, but need to be monitored to avoid negative surprises. Our watchlist is as follows:Tightening liquidity will likely influence market sentiment next year. Any excessive liquidity withdrawal will likely challenge the above positive scenario.The potential retirement of long-serving PBO governor Zhou will create uncertainty. The new leadership team will need to earn market confidence.Interest rate hikes in the US can potentially dampen asset prices globally. 2017 showed the Federal Reserve’s ability to move without negative impact but this needs to continue in 2018.Rising geopolitical risk in North Korea and Middle East is a semi-permanent uncertainty that one must monitorLast but certainly not least, the US tax cut on corporate earnings can potentially cause outflows from emerging markets. Both capital repatriation and shifting expansion plans by US firms need to be monitored.We believe these risks are low probably events. We are comforted by the track record of both the Federal Reserve and the Chinese authorities to manage their liquidity withdrawals prudently. China will tighten liquidity if and only if macro-economic growth is strong enough to absorb the impact. Similarly, the Federal Reserve has given us no reason to doubt their methodical and data dependent approach. Importantly, should a global market correction occur, we believe Chinese A-shares are the most insulated asset class among global equity markets. Regards, David

Dec 19, 2017

In the same month that US residents were busy celebrating Thanksgiving and preparing their shopping lists for Black Friday, Chinese online spenders created another sales record in the annual November 11 consumer festival, known as Singles Day in China. The total gross merchandise volume (GMV) on Alibaba’s platform reached RMB 100 billion in the first 3 hours, and eventually became RMB 168 billion (or ~USD 25.3 billion) by the end of the day. The GMV is 3 times bigger than the combined sales of Black Friday and Cyber Monday in the US. A total of 812 million orders were generated in 24 hours, which equates to 9,400 orders per second. With the assistance of big data in facilitating faster delivery from closer warehouses and stores, the first order arrived at the customer’s door 12 minutes after purchase! Interestingly, 90% of payments went through mobile phone, compared to 41% just 3 years ago. It shows that mobile payment systems are getting more sophisticated rapidly in China and are way ahead of the West, where only 30% of shoppers used mobile payment during Black Friday in the US.Instead of simply looking at this as another consumption record, we believe this phenomenal event has a few implications to investors:China’s consumption story is real and remains strong despite a macro economy slowdown. Since everyone is buying from their savings at the moment, the industry outlook will be even brighter as consumer finance begins to pick up.Domestic consumption is capable of taking over from net exports and investment in driving economic growth, with consumption accounting for 64.5 percent of the headline growth or 4.4 percentage points in the first 9 months this year.There are innovative companies in non-consumer industries such as logistics, financial services and technology that are accelerating their development in order to cater for the increasing demand of Chinese consumers. Without the support of a reliable ecosystem, it is hard to accommodate the vast orders coming in and to ensure on-time delivery.China is already the world's largest e-commerce market and the share of online shopping that makes up all consumer spending grows every year. BCG forecasts online spending will rise by 20 percent annually to USD 1.6 trillion by 2020, compared with ~6 percent growth for brick-and-motor retail sales.For investors, the most direct exposure to this trend could be buying companies that operate online retailers/platforms and/or provide related infrastructure services. But the danger is that these companies are well known and a lot of the potential is already priced in. Strategies focused on consumption or new economy sectors may provide an alternative and more diversified way to benefit from this long-term trend. At Premia, we launched precisely such a strategy with 3173 HK. You can read about our approach here, or review the product details here.Beyond China, there are also some newly listed ETFs that offer an opportunity to express a pessimistic view on offline retailers by outright short-selling them or going long online retail while short-selling traditional retail.On a more personal front, you may be wondering if I contributed to the record sales of Singles Day this time around? In fact, I just bought a new electric scooter for USD 290 for my short-distance travel. Since I’m still waiting for it to arrive, guess there’s always room for further improvement in operations.Source: Bloomberg, Boston Consulting Group, Nov 2017

Nov 30, 2017

It’s been a month since we launched our ETFs and we’ve been asked by a few clients to walk through a quick synopsis of A-shares vs rest of world, as well as the various options available within A-shares. I thought it would be easiest to cover these topics through a valuation and mean reversion lens, as that seems to be the angle missing from many of the comments I see about continued performance upward.Valuations overallNick Ferres, Vantage Point’s CIO, covers the risks quite well here, so I’ll start with a summary of his points. Technology stocks have seen positive price movement justified by their earnings so far, but the latest moves up have been parabolic and likely entering the last phase of the bull market before a potentially aggressive correction. Speculative excess can be seen elsewhere as well, from bitcoin to art auctions. Here’s my very simple monitor for the same thing: Source: Bloomberg, as of 21 November 2017 Forward P/E ratios are higher than their 10yr averages in every major DM and EM market except Japan. The premium ranges from 12% to 24%. The highest is in China offshore stocks while the lowest, curiously enough, is in China A-shares. Similarly, on a Price to Sales (P/S) basis, all markets are higher than their 10yr averages. EM has the lowest premiums (again, with China offshore stocks being the exception), but that is likely driven by the tech rally, which you can see all the way on the right. The tech sector has a P/S premium of ~60-70%! Tech sector earnings growth justifies some of the premium, but the valuation levels today suggest a recovery not far on the horizon. A-shares vs rest of world In a world of high valuations across the board, a long-only investor needs to do 2 things to protect their portfolio: 1) identify the catalyst likely to cause the rally to sputter, and 2) identify a market that has lagged (and is therefore cheap) and has relatively low correlations with the rest of the world. The charts above give us a hint for the latter, but let me quickly share my thoughts on potential catalysts. In my mind, there are 2 catalysts big enough for investors to stand up and notice and geopolitics is not one of them. Short of outright war, investors have from time and time again shown a willingness to ignore geopolitical risk. The bigger issues in my mind are a failure of US Congress to pass tax reform and disappointing news from the FANGs, BATs or any of the other major tech firms. US tax reform is far from a done thing and as the debates on travel bans and healthcare reform have shown, a desire to act is far from an ability to act. A failure on this front would cement a mindset that President Trump cannot accomplish much of anything and that the lofty valuations and confidence underpinning current market levels may not be warranted. On the tech side of things, I don’t think it would take much for investors to take profit. Earnings growth expectations are quite high and even a “just OK” number might be an opportunity for some to exit. The looming possibility of greater regulation is also not out of the question. If either of these events occur, where can we seek refuge? You guessed it! A-shares are not only relatively cheap, but are also under-owned by investors, uncorrelated with the rest of global markets and have a large wall of money (both foreign and domestic) coming their way. From a fundamental asset allocation point of view, A-shares volatility has trended down materially in recent years, the RMB is stable, IPOs are decreasing, and the economy is quite robust. All in all, a good story that can be summed up in 6 quick charts. Source: Shanghai & Shenzhen Exchanges, Bloomberg, as of 21 November 2017 A-shares with nuance If you agree with the above logic and are thinking of adding A-shares to your portfolio (or already have them), then the next question is deciding how to obtain the exposure. We’ve already spoken about the issues with existing beta options for mainstream exposures here and the lack of new economy options here. Today, I’d like to dig into style and sector performance to show why a simple mkt-cap construct is not your best bet. From a style point of view, the 2 most common strategies globally are value and small size. In developed markets, value has consistently outperformed since the ‘70s, but has suffered vs growth over the last few years. Small caps have not had such issues, showing consistent outperformance across pretty much every period. You can see the details below: Source: Bloomberg, as of 21 November 2017 What do these charts look like in A-shares? Given their uncorrelated nature, we see the exact opposite pattern over the last few years! Value has consistently outperformed but small caps have experienced a massive correction over the last 1 year. Coming off non-sensical highs in 2015, small caps have re-rated massively vs large caps, underperforming by ~12% annualized since the peak of 2015. Source: Bloomberg, as of 21 November 2017 Some investors might view this as proof that one should invest in China mega-caps only and leave the rest alone, but we take a different view. Coming back to valuations, it is evident that 2015 small cap multiples were unrealistic and have simply corrected to their long-run average (in fact, below it if you include the peaks as the chart below does). In contrast, large caps are flirting with their 2011 and 2015 valuation peaks. Source: Bloomberg, as of 21 November 2017 Size on its own can be quite volatile and we suggest that a singular focus on the size factor be handled with caution. As a result, we decided to take a multi-factor approach for our Bedrock Economy and New Economy ETFs. 2803 HK (Bedrock) provides a value, balance sheet health, low vol and low size bias. While this has resulted in underperformance so far in 2017, the combination of value and size exposure should generate substantial excess return going forward. 3173 HK (New Economy) is a services sector play – focused on consumer discretionary, technology and healthcare sectors. Its diversified sector exposure and balance sheet health, profitability and R&D bias has resulted in material outperformance vs Chinext so far this year, but significant size bias has detracted from performance relative to the large cap benchmarks. Source: Bloomberg, as of 30 September 2017 To wrap up, A-shares are a relatively cheap alternative to global markets’ increasingly stretched valuations. The challenge is what type of China exposure investors want to have in this market. Mainly large cap banks and some industrials and real estate? Then FTSE A50 or CSI 300 are the way to go. For a broader but still traditional exposure, 2803 HK lowers financials to more reasonable levels, adds consumer discretionary and prioritizes value and size factors to deliver excess return. Or, for those who want to focus on new vs traditional economy sectors, 3173 HK offers close to 0 financials, real estate and energy stocks and instead targets consumer discretionary, technology and healthcare stocks while prioritizing size and balance sheet health factors.

Nov 28, 2017

Most investors agree that EM economy drivers are shifting from financials and energy to technology, consumption, healthcare, education and sustainable growth. Yet when we actually invest in EM, and onshore China, we simply focus on the largest listed stocks, i.e. yesterday’s drivers. One size does not fit all in China beta and today we dive into a new economy approach for A-shares that is a must for the long-term.

Oct 18, 2017

We are modernizing the Asian beta landscape and lowering costs as well.  For those reading our past posts, you’ll know we are planning to list new A-share beta strategies, improving on what exists today in both design and cost.  We are finally at our destination, with HKEx listing scheduled for Oct 24 subject to final regulatory approvals. 

Oct 13, 2017

A-shares are a deeper, broader, cheaper and less correlated market than offshore Chinese equities. Investors should review their portfolios given the benefits of A-shares to overall asset allocation.

Sep 28, 2017

Size works in A-shares, but for this article we'll put that aside and focus on implementation feasibility.

Aug 01, 2017

Without any screening or selection, solely investing in all SOEs or the largest market cap SOEs may not be optimal strategies. What is important for investors is how to capture the current contributors and engines for future growth of China economy regardless whether the underlying stocks are SOEs or non-SOEs.

Jul 04, 2017