Sell-off presents potential entry point to China ETFs

Aug 25th, 2015 | By | Category: Equities

Following a 21% fall in China’s Shanghai Composite over the past five days and devaluation of the yuan, now could be an opportune time for contrarian investors and/or those with long investment horizons seeking a target allocation to the world’s second-largest economy to begin to progressively build a position in ETFs exposed to the country’s equity and bond markets.

Could the Chinese market slump be a buying opportunity?

Chinese equity markets have fallen sharply in recent days, potentially presenting an opportune entry point for contrarian and long-term investors.

Expectations for an interest rate cut and a lowering of bank’s reserve requirements from the People’s Bank of China (PBoC) were fulfilled on Tuesday in an effort by the country’s central bank to shore up markets and stimulate the economy. This is another in a long line of measures Beijing has taken to support the equity market and they certainly have the firepower to continue doing so.

“We believe the correction in Chinese equities is at odds with China’s fundamentals. China’s economy is much healthier than at the time of the 1997 Asian crisis, with huge FX reserves (34% of GDP and the largest in the world at over $3.5 trillion), a healthy current account surplus (2.8% of GDP) as well as a moderate fiscal deficit (2.3% of GDP). Furthermore, China is unusual among large economies in that the authorities still have plenty of means available to stimulate growth via both fiscal and monetary means,” said Mansfield Mok, Portfolio Manager at New Capital China Equity Fund.

The recent fall in share prices is not all bad news for investors – at least not for those investors who were on the sidelines or who had not yet reached their target China allocation. Valuations have corrected and could constitute an ideal entry point for long-term investors willing to ride the short- and medium-term volatility of these markets.

Earlier this month, Alexander Redman and Arun Sai at Credit Suisse noted that the earnings multiple of the MSCI China Index (which includes Hong Kong listed H-shares but not the domestically listed A-shares) is trading on a sector-adjusted 12-month forward earnings multiple of 9.5 times, which is a 16 percent discount to the average over the past 20 years. This multiple will be even less now and the discount even greater, although of course investors should expects some earnings downgrades.

There are concerns that rising interest rates in the US could have a detrimental effect on emerging market countries such as China. According to Michele Mazzoleni at Research Affiliates this may not be the case: “Higher interest rates can be good news if they signal stronger economic performance. Solid growth rates tend to be associated with higher interest rates and the rest of the world can benefit from strong US growth. Indeed, the United States is still the world’s largest economy, and an improvement in US economic performance should pave the way for expansion at the global level.”

He added: “Moreover, economic growth can also influence investors’ attitudes toward risk. Good times lead to increasing risk appetites and may encourage investors to diversify away from the expensive US market. The desire to reallocate assets tends, in turn, to stimulate a rally in foreign financial markets.”

Slowing growth continues to be a focal point of China bears, but GDP is still expanding at impressive levels (levels leaders of developed Western countries would give their eye teeth for!) and the recent devaluation of the yuan should provide further support through increased exports.

The quality of this growth is improving too. Recent GDP releases have shown the success China has had rebalancing its economic output. Growth is increasingly being driven by domestic demand, evidencing the country’s success in moving from an investment-driven to a consumption-driven economy – a balance which is necessary for long-term sustainable growth.

According to Tai Hui, Chief Market Strategist for JP Morgan Funds in Asia, there is a case for investment in China for the long-term: “Based on key investment themes such as middle-class consumerism, the One Belt, One Road initiative and the policy drive for environment protection and renewable energy. In addition, the real estate market is stabilising after an 18-month correction, which is good news for developers. Despite the recent volatility, we still believe Chinese onshore equities are on track for inclusion in global emerging market benchmarks (MSCI in particular) in the next few years, which would stimulate international capital flows.”

Whilst equities have suffered, Chinese sovereign bonds have been relatively stable: “Global stock markets are taking serious hits over concerns that China’s growth is significantly slowing, and the impact this has for the world economy. Bonds on the other hand, have been relatively stable, and despite Chinese Yuan devaluation earlier in the month, Chinese sovereign bonds haven’t moved much,” said Heather McArdle, Director, Fixed Income Indices at S&P Dow Jones Indices.

What does this say about Chinese sovereign bond markets? “They have low correlation to the Chinese equity market. They behave like most other AA rated bonds in terms of lower volatility and “flight to safety” behaviour. Chinese sovereign bonds also have relatively higher yields compared to other AA rated countries,” said McArdle.

Exposure to the yield opportunities in Chinese sovereign bonds can be gained through the db x-trackers II Harvest CSI China Sovereign Bond UCITS ETF (CGB LN) which tracks the performance of the CSI Gilt Edged Medium Term Treasury Note Index.

For investors who are confident in the long-term growth prospect for China or those with faith that Chinese regulators will support equity markets, there are a number of European listed China A-shares ETFs available, such as the db x-trackers Harvest CSI300 Index UCITS ETF (DR) (RQFI LN), the Source CSOP FTSE China A50 ETF (CHNA LN), the Lyxor UCITS ETF CSI 300 A-Share C-USD (GBP) ETF (CSIL LN), the iShares MSCI China A UCITS ETF (CNYA LN) and the ETFS-E Fund MSCI China A GO UCITS ETF (CASH LN).

If capital does begin to flow back into the country this would be positive for the yuan and the PBoC’s considerable currency reserves should also provide a backstop in the event of significant devaluation. Long exposure to the country’s currency and to the attractive income potential of their money markets can be gained through the Commerzbank CCBI RQFII Money Market ETF (CCMG LN).

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