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Opinion

Consumers, not MSCI managers, will drive Chinese stocks

But index change will bring domestic companies and foreign investors closer together

| China
As highlighted in officials' comments at the National People's Congress, policymakers stand ready to pull further on monetary and fiscal levers.    © Reuters

Many global investors view China's domestic stock markets as almost hopeless. They have historically been volatile, momentum-driven and influenced more by short-term retail investors than long-term institutional funds.

After sinking more than 30% last year, China's domestic markets have rallied sharply since the start of 2019. Some observers expect the markets to get a further lift from the February 28 decision by index company MSCI to increase the weighting of Chinese domestic shares in its regional and global stock indexes.

But for us as stock pickers, the move has no immediate practical implication. Our view as to whether a given company is good or bad or whether or not its shares are attractively priced is not affected by MSCI's judgment on whether to include it in its indexes or how much weight to give it if so. We will not be adjusting our portfolios based on these decisions either.

In the long run, though, there are compelling reasons, some related to MSCI, for international investors to view this market more favorably.

China's stock markets are huge, with some 3,500 listed companies and a market value of around $8.5 trillion. But the markets remain inefficient, with 80% of turnover emanating from local retail investors who are more easily swayed by news headlines than the long-term earnings prospects of domestic companies.

These investors were bombarded with negative news last year about China's slowing economic growth, rising bankruptcies and U.S. import tariffs. This undermined confidence and put the brakes on corporate spending plans.

The sell-off, however, was excessive. While the trade conflict with the U.S. has had some impact, the current slowdown has largely been a result of the authorities' drive to curb the use of debt to fuel growth in order to safeguard the financial system. It should thus be a positive for the market in the long term.

What is more, Beijing has made a point of late of supporting the expansion of domestic consumption of goods and services. This will contribute to achieving the authorities' goal of building a more self-sufficient, sustainable economy.

In response to the economy's short-term challenges, policymakers have been rolling out measures to stimulate select sectors and they stand ready to pull on monetary and fiscal levers further to help smooth the economic transition, as highlighted in officials' comments this week at the National People's Congress in Beijing.

Global investors should remember that this is an economy still growing more than 6% a year, much faster than any developed market. Despite widespread warnings from Chinese companies about falling short of their previous guidance on 2018 profits, analysts still expect domestically listed companies to report average earnings growth of 15% this year.

Few other markets can match China's double-digit income growth. Moreover, even with the recent rebound, domestic shares are still trading at a forward price-to-earnings multiple of less than 13, a level not seen since 2014 until last year's slump, according to Bloomberg data.

Over time, increases in the weighting given to Chinese stocks by MSCI will have an impact on inflows. Some observers forecast that domestic stocks could represent as much as 20% of the widely followed MSCI Emerging Market Index within five years, up from 0.8% now. This would draw in capital from foreign institutional funds tracking the index passively.

This would be long-term money, stickier than the sentiment-driven flows we see today. This shift would help expose local companies to global standards of accountability and best practices. That should in time raise governance standards and make the market more investable. Well-run companies with good capital management make better investments over time in our view than companies that do not meet these standards.

Global investors may already be invested in China via mainland companies which have listed their shares offshore, especially on the Hong Kong market. Such shares now dominate the MSCI China Index, given the current discounted weighting of domestic stocks, but this will gradually change.

There are more than 10 times more Chinese companies listed domestically than in Hong Kong. Overall trading turnover and market capitalization are higher onshore, too.

The domestic stock markets are also more diversified than the world of offshore China shares, especially in regard to consumer-oriented stocks which appear to offer the brightest earnings prospects amid the country's economic transition. Recall that China's middle class is growing fast, with 380 million millennials earning and spending more than their parents ever did on luxury items, travel and health care.

Moreover, the domestic share market moves more to its own rhythm as compared with the MSCI China index, which is far more influenced by global markets. So greater exposure to domestic Chinese stocks can bring valuable diversification benefits to a global portfolio.

As China's representation in global bench marks grows, investors will be increasingly confronted with the necessity of considering how much exposure is appropriate for them. Domestic shares may have long seemed more trouble than they are worth, but such blanket judgments should be reconsidered.

Nicholas Yeo is head of China equities at Aberdeen Standard Investments.

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