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06 Nov 2017

What change in China (or otherwise) means for your portfolios



Xi 3.0? 

Xi Jinping seems to have strengthened his grip on power after the most recent Communist Party Congress. This should give him a better chance of pushing through his vision of Party-controlled reform.

While such a model may not generate the best long-term potential growth, it should still help mitigate debt risk, contain deflationary pressure and support consumption over the medium term. Slower growth is a sacrifice the leadership seems willing to make. But what does this mean for investors?


An alphabet soup of indices 

There are many ways of investing in China today. In fact, with so many options available, the choice can be baffling. Indices can have almost identical names, but offer vastly differing exposures and very different returns. How then do we decipher this alphabet soup of indices offering “broad, diversified exposure to China equities”? In our view, it’s best to look at the ingredients.


How China indices have performed

 

 

How China indices have performed

 

No longer as simple as A or H

China is now the world’s second largest equity market by capitalisation. That growth has come with greater awareness of the nuances of the A- and H-share markets, and the fact that there’s long been a premium associated with investing in the former. That premium endures, but it has become much less volatile, and much less marked, in recent years as the connectivity between the two markets has increased. 

A-shares will finally start being added to the MSCI Emerging Market index from June 2018. This integration will be limited initially and gradual, as more needs to be done on corporate governance, suspensions, trading limits, transparency. Yet this is a positive signal, and it should have an impact on confidence and capital inflows.

That said, we still believe it’s more important to look beyond questions of A and H right now and dig deeper into the nature of the companies your choice of index exposes you to.   


Know your ingredients 

There has been a big rally YTD in China, but the various indices have performed very differently. For once though, the driver is not onshore/offshore but the scale of the exposure to the traditional state-owned enterprises (SOE) or the new tech giants. The effects of this two-speed economy are plain to see in the chart below. Valuations in some of the more consumer-led areas – including tech – are now looking very stretched indeed. 

 

  • China two-speed market: trailing P/E ratios in consumer-related and other sectors 

Know your ingredients

(*) Consumer-related sectors include MSCI China Technology, Consumer discretionary and Consumer  staples. Source: Bloomberg, SG Cross Asset Research/Equity Strategy 

Open sesame​

Tencent and Alibaba ADR – which together represent around 75% of China’s tech sector and around 30-40% of indices like the MSCI China  – have delivered stellar returns of 80%+ and 100%+ respectively so far this year.

For those share prices to keep rising as they are, we need to see a continuation of the phenomenal earnings growth of the last ten years, but this looks unlikely. c. 50x Forward P/E doesn’t look sustainable to us. Earnings growth is much more at risk in the new economy as markets mature and competition rises.

As privately owned firms, the tech titans won’t benefit from Xi’s vision of the role of the Party and the State in the economy. They may in fact be held back as they are called on to become strategic investors in businesses in which they’d never normally invest. That said, we’re not calling the end of the tech boom, merely advocating a better portfolio blend of old and new.

Don’t look back in anger​

Many of the stalwart SOEs of days gone by are now under new, more progressive management and starting to enjoy the fruits of reforms on mixed ownership and reducing capacity. In our view, making them more productive and freeing up resources from inefficient SOEs is the most critical reform for long-term growth.

The three main components of the reforms – mixed-ownership, mergers and capacity reduction – are all expected to speed up from here. Whether they will truly make SOEs more efficient over the longer term is unclear, but they will increase the capital they have at their disposal, and boost market shares and pricing power in the short term. That will support some indices more than others. You may need to look back to move forward.


Where you find SOEs​

 

  • SOE share in the industrial sector (in terms of assets, 2015)

Where you find SOEs​

Source: NBS, SG Cross Asset Research/Economics

 

 

  • SOE share in the services sector (in terms of assets, 2013*)

SOE share in the services sector (in terms of assets, 2013*)

* 2015 data are used for retail sales, wholesale and catering services sectors. Conservative estimates made for financial services, accommodation, and real estate sectors, due to lack of data. The asset size of financial services is CNY162tn in 2013, a number too high to show in this chart.Source: NBS, SG Cross Asset Research/Economics

Old, but gold 

So which indices allow you to play the old economy theme? Broadly speaking, the indices fall into two main camps – financials tend to form the major part of H-share indices while it’s the consumer-related sectors (where the presence of SOEs is least felt) and industrials that lead for A-shares. If tech valuations concern you, the HSCEI Index may be a good bet. As the table below shows, it avoids the sector completely. 

Index Exposure Shareclasses No of stocks Consumer Discretionary Consumer Staples Energy Financials Healthcare Industrials IT Materials Real Estate Telecoms Utilities
MSCI China Offshore H,B, Red chips, P chips, ADRs 150 10.1 2 4.8 22.4 2 4.6 40.3 1.3 4.9 5.3 2.3
Hang Seng China Enterprise Offshore H 40 3.8 0 10.6 72.6 1.4 5.3 0 1.3 1.2 1.8 2.1
CSI 300 Onshore A 300 11.7 7 - 34.8 4.6 14.4 9.1 7.5 5.2 - 2.7
MSCI China A Onshore A 581 12.5 7 - 23.5 6.6 16.7 10.3 11.8 5.7 - 3
MSCI China A International Onshore A 369 11.2 8.3 2.5 26.7 6.2 16.8 8.8 9.7 5.3 0.8 3.6


Source: Bloomberg, MSCI . 3 November 2017

 

One other thing to note, China has proven a particularly tough nut for active managers to crack in recent months, with just 12% of managers outperforming in Q3. Over 10 years, only 37% have beaten the benchmark*.

*Source: Morningstar and Bloomberg data from 30/09/2007 to 30/09/2017.

 

Risk Warning 

It is important for potential investors to evaluate the risks described below and in the fund prospectus which can be found on www.lyxoretf.com

CAPITAL AT RISK: ETFs are tracking instruments: Their risk profile is similar to a direct investment in the Underlying Index. Investors’ capital is fully at risk and investors may not get back the amount originally invested. 

REPLICATION RISK: The fund objectives might not be reached due to unexpected events on the underlying markets which will impact the index calculation and the efficient fund replication. 

COUNTERPARTY RISK: Investors are exposed to risks resulting from the use of an OTC Swap with Societe Generale. In-line with UCITS guidelines, the exposure to Societe Generale cannot exceed 10% of the total fund assets. Physically replicated ETFs may have counterparty risk resulting from the use of a Securities Lending Programme. 

UNDERLYING RISK: The Underlying Index of a Lyxor ETF may be complex and volatile. When investing in commodities, the Underlying Index is calculated with reference to commodity futures contracts exposing the investor to a liquidity risk linked to costs such as cost of carry and transportation. ETFs exposed to Emerging Markets carry a greater risk of potential loss than investment in Developed Markets as they are exposed to a wide range of unpredictable Emerging Market risks. 

CURRENCY RISK: ETFs may be exposed to currency risk if the ETF is denominated in a currency different to that of the Underlying Index they are tracking. This means that exchange rate fluctuations could have a negative or positive effect on returns. 

LIQUIDITY RISK: Liquidity is provided by registered market-makers on the respective stock exchange where the ETF is listed, including Societe Generale. On exchange liquidity may be limited as a result of a suspension in the underlying market represented by the Underlying Index tracked by the ETF; a failure in the systems of one of the relevant stock exchanges, Societe Generale or other market-maker systems; or an abnormal trading situation or event.

This document is for the exclusive use of investors acting on their own account and categorized either as “eligible counterparties” or “professional clients” within the meaning of Markets in Financial Instruments Directive 2004/39/EC. It is not directed at retail clients. In Switzerland, it is directed exclusively at qualified investors. 

Some of the funds described in this communication are sub-funds of either Multi Units Luxembourg or Lyxor Index Fund, being both investment companies with Variable Capital (SICAV) incorporated under Luxembourg Law, listed on the official list of Undertakings for Collective Investment, and have been approved and authorised by the CSSF under Part I of the Luxembourg Law of 17th December 2010 (the “2010 Law”) on Undertakings for Collective Investment in accordance with provisions of the Directive 2009/65/EC (the “2009 Directive”) and subject to the supervision of the Commission de Surveillance du Secteur Financier (CSSF). Alternatively, some of the funds described in this document are either (i) French FCPs (fonds commun de placement) or (ii) sub-funds of Multi Units France a French SICAV, both the French FCPs and sub-funds of Multi Units France are incorporated under the French Law and approved by the French Autorité des marchés financiers. Each fund complies with the UCITS Directive (2009/65/CE), and has been approved by the French Autorité des marchés financiers. Société Générale and Lyxor AM recommend that investors read carefully the “risk factors” section of the product’s prospectus and Key Investor Information Document (KIID). The prospectus and the KIID are available in French on the website of the AMF(www.amf-france.org). The prospectus in English and the KIID in the relevant local language (for all the countries referred to, in this document as a country in which a public offer of the product is authorised) are available free of charge on lyxoretf. com or upon request to client-services-etf@ lyxor.com. The products are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on NYSE Euronext Paris, Deutsche Boerse (Xetra) and the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them.Updated composition of the product’s investment portfolio is available on www. lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed. Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice.It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document together with the prospectus and/or more generally any information or documents with respect to or in connection with the Fund does not constitute an offer for sale or solicitation of an offer for sale in any jurisdiction (i) in which such offer or solicitation is not authorized, (ii) in which the person making such offer or solicitation is not qualified to do so, or (iii) to any person to whom it is unlawful to make such offer or solicitation. In addition, the shares are not registered under the U.S Securities Act of 1933 and may not be directly or indirectly offered or sold in the United States (including its territories or possessions) or to or for the benefit of a U.S Person (being a “United State Person” within the meaning of Regulation S under the Securities Act of 1933 of the United States, as amended,and/or any person not included in the definition of “Non-United States Person” within the meaning of Section 4.7 (a) (1) (iv) of the rules of the U.S. Commodity Futures Trading Commission.). No U.S federal or state securities commission has reviewed or approved this document and more generally any documents with respect to or in connection with the fund. Any representation to the contrary is a criminal offence. This document is of a commercial nature and not of a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.These funds include a risk of capital loss. The redemption value of this fund may be less than the amount initially invested. The value of this fund can go down as well as up and the return upon the investment will therefore necessarily be variable. In a worst case scenario, investors could sustain the loss of their entire investment. This document is confidential and may be neither communicated to any third party (with the exception of external advisors on the condition that they themselves respect this confidentiality undertaking) nor copied in whole or in part, without the prior written consent of Lyxor AM or Société Générale. The obtaining of the tax advantages or treatments defined in this document (as the case may be) depends on each investor’s particular tax status,the jurisdiction from which it invests as well as applicable laws. This tax treatment can be modified at any time. We recommend to investors who wish to obtain further information on their tax status that they seek assistance from their tax advisor. The attention of the investor is drawn to the fact that the net asset value stated in this document (as the case may be) cannot be used as a basis for subscriptions and/or redemptions.The market information displayed in this document is based on data at a given moment and may change from time to time. Authorizations: Lyxor International Asset Management (Lyxor AM) is a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2009/65/EC) and AIFM (2011/61/EU) Directives.Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority

Research Disclaimer

This material reflects the views and opinions of the individual authors at this date and in no way the official position or advices of any kind of these authors or of Lyxor International Asset Management and thus does not engage the responsibility of Lyxor International Asset Management nor of any of its officers or employees. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and principal trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, principal trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research.

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