China equity markets at an exciting juncture

Further loosening of capital controls and opening up of the two markets’ access is just a matter of time

It is hard not to notice the excitement the China equity markets have generated over the last few weeks, in terms of both returns and volume. The China A-share market, which has nearly doubled in the last 12 months, recorded daily turnover of US$290bn while the Hong Kong market rose over 30% since March 2014 and reached its own record of US$37bn daily turnover not too long ago. In our view, positive structural reform progress has played a large part in driving the strong returns, by reducing the left tail risks that have been associated with China and improving the sustainability and quality of growth. However, the rally alone would not have multiplied trading volumes to the extent that we have seen. In terms of volumes, we think the key catalyst behind this was the CSRC’s announcement that domestic funds (even those without QDII quota) would be allowed to invest in the Hong Kong market via the MMA scheme. Historically, capital account controls have meant that almost all of the funds in mainland China were limited to domestic investment options (aside from a very small QDII channel through previously defined QDII funds). But the opening up of market access could mean markets such as Hong Kong could see a larger influx of funds.

Further loosening of capital controls and opening up of the two markets’ access is just a matter of time. The A-share and H-share markets remain largely separate with limited overlap in the pool of funds that drive these markets for now. The only access points are approved QFII/RQFII/QDII quotas and the MMA scheme. These all have stringent limitations, such as eligible investors, the investible list of stocks, and the cross-border trading size allowed, to name a few. As China moves towards eventual capital account opening, we see continuous steps being made to remove these limitations. For example, more retail and institutional investors will be able to use the MMA over time, QFII/RQFII/QDII quotas are likely to be meaningfully upsized, the Shenzhen Stock Connect to come later this year will probably increase the list of investible stocks on both sides as well as the daily and cumulative trading volumes allowed. Eventually, once capital account opening is complete, the A-share market will be completely open to global investors while domestic investors will also have full freedom to ‘go out’. The two pools of capital will be merged. We believe the reforms to move towards this long-term objective will continue to positively surprise in terms of timing and impact.

The path to convergence brings abundant opportunities, but be selective. What are the differences between the two markets that may eventually disappear? Both prices and liquidity in our view. The market has been focusing on the price discrepancies, with the A-H dual listed stocks seeing their premiums contract meaningfully in the past weeks. For some stocks and sectors, the move is warranted, but for some others, H-share valuations have now moved to levels that look excessive vs their (non A-share) regional and global peers. We prefer to be more selective and focus on those where we think valuations are still attractive on an absolute basis and relative to regional and global peers (rather than buying on the basis of valuation relative to A-shares only). Some of these opportunities may lie in the less obvious areas e.g. not the A-H dual listed space necessarily. On the liquidity differences, we see that both an actual increase in the participation on the Southbound as well as the anticipation of more domestic investor buying have boosted the Hong Kong market turnover. Given the huge gap between A-share turnover and velocity vs H-share, we think the improving H-share turnover is the ‘new normal’ as more A-share funds flow south. In the past 3-5 years, despite some small and mid-caps offering better growth than their large cap counterparts, they have seen discounted valuations due to lower liquidity and greater risk. As structural reforms continue to reduce the tail risks in the economy and Hong Kong market turnover improves, we expect to see the large cap premiums dissipate. Indeed, in the A-share market, small and mid-caps tend to trade at noticeable premiums across most sectors. Some H-share sectors where we still see good value even after the recent run-up include mid cap banks, property, utilities/new energy; while areas like construction, capital goods, transport and energy have moved to less attractive valuations largely due to the A-H price gap issue. We would be selective and continuously flexible looking forward, in terms of sector picking and choosing between A and H share investment opportunities.

Helen Zhu – Head of China Equities – BlackRock