This June, MSCI will start including Chinese A-Shares in its global index series for the first time. The move will be done in two steps: one in June and the second in September. The move is highly symbolic and a further important step in the opening of China's capital account. In this update, Thomas Schaffner, who amongst others runs the Vontobel Fund - mtx China Leaders, sheds light on how investors can make the most out of a broadening of the index.
The inclusion will be slow and gradual as MSCI will be using a relatively low inclusion factor. China A-Shares will account for only 0.8 percent in the MSCI EM Index ‒ this compares to the 5.5 percent weight of Tencent, a leading provider of Internet value added services in China and the largest constituent of the MSCI EM Index. While certainly symbolic and widely publicised, the move will have little impact on trading volumes as the domestic markets in China are highly liquid and driven by domestic investors. China will still be underrepresented in the MSCI series compared to its economic importance on the global stage.
A-Shares represent onshore stocks traded in Shenzhen and Shanghai. A-Shares have been initially available only to foreign institutions under strict quotas set by the Chinese government and later through the Hong Kong – Shanghai and Hong Kong Shenzhen Connect Programs. The two domestic markets on their own represent the world's second largest equity market by market capitalization. With the inclusion of China A-Shares in the MSCI EM Index, we believe that foreign investor demand will increase. The number of A-Shares with approximately 3,500 is significantly larger than the number of stocks which are currently included. In our screens, we use more than 500 A-Shares which are the largest in terms of market capitalization and the most liquid.
"The onshore markets are both broader and deeper than the offshore markets. This provides significant opportunities to active stock pickers like the Vontobel mtx Team.
Currently, China accounts for 31 percent of the MSCI EM, while the overall share of the A-Shares is very small, a total of 233 new stocks will be added into the index in 2018. MSCI uses an inclusion factor of only 5 percent, which explains the low weight. That said, over time we expect that the inclusion factor will be lifted.
A-Shares have a different composition compared to the existing MSCI China constitutes. The broader indices are trading at similar valuations. However, domestic A-Shares are now trading at a discount to their historic average. The incremental buying of foreign investors and index trackers are likely to support the valuation of A-Shares.
Even in times of pressure due to the ongoing trade row between the U.S. and China, we remain constructive on Chinese equities and the Chinese economy. The trade war is indeed a risk we monitor closely, however, we do not expect a significant reversal in global trade as it would hamper growth prospects for the global economy. We also expect that the current tightening on off-balance sheet structures and the property market as well as the enforcement of environmental standards will have a slight negative impact on growth. However, these measures lead to an improvement in the overall quality of the growth and to a significant reduction of long-term risks.
"Solid economic conditions in China and a recovery of corporate profitability and cash flows will ultimately prop up ROICs."
Looking at companies, which is our specialty, the improving pattern in Return on Invested Capital (ROIC) we have been observing since last year is still going on. Solid economic conditions combined with more disciplined capital expenditure as well as the supply side reforms in China is leading to a recovery of corporate profitability and cash flows, which ultimately will prop up ROICs.