万事开头难 – All things are difficult before they are easy

Twenty-five years ago, China’s exports were half of France’s and one-quarter of Japan’s. Now it is the world’s largest supplier of manufactured goods. Its rise contributed to the developed world’s “great moderation” in the 2000s, as cheaper goods helped keep inflation in check.

In building its roads, bridges, dams, rail networks, and cities, the country became the world’s largest importer of commodities, and now accounts for 57% of annual global demand for iron ore and 50% of copper. Commodity-exporting fortunes were built on supplying this demand, and today the welfare of many regions rests, in large part, on China’s continued economic progress.

With the world’s manufacturing industries and commodity markets transformed, the third wave of Chinese modernization is now approaching. In the years ahead, the country’s capital markets will become increasingly integrated within the global financial system.

This third wave presents opportunities and risks alike. Participating in China’s growth sectors, from e-commerce to clean energy, will become easier. But China’s corporate debt-to-GDP ratio is approaching levels reached by Spain and Japan before their respective crises, a huge but opaque shadow banking system is raising concerns, and both policy and investment flows are likely to remain unpredictable. In this letter I look at the implications of China’s third wave for global investors.

Meanwhile, in our global tactical asset allocation we make three changes:

First, although corporate earnings growth is robust and we remain confident in the US economy, the recent rise of the US stock market leaves it less scope to outperform global equities, in our view. We remove our explicit US equity overweight position and replace it with an increased overweight in global stocks, relative to high grade bonds.

Second, within Europe, we overweight Eurozone equities relative to UK equities. UK earnings are likely to come under pressure due to a stronger pound and falling commodity prices, while investors are likely to give the Eurozone more credit for its economic growth now that the French election has passed.

Finally, we shift our underweight position in the Canadian dollar versus the Swedish krona to an underweight in the Swiss franc against the krona. We expect reduced safe haven demand for the Swiss franc to contribute to outflows from the currency, while the krona should be supported by strong GDP growth and close-to-target inflation.

The third wave

Relative to its size, China is heavily underrepresented in most international investors’ portfolios. Despite having the world’s second-largest equity market (with a value of around USD 7.5trn) and third-largest bond market (USD 9.4trn), it constrains capital mobility and often exhibits prodigious volatility. These factors have limited its accessibility and appeal to international investors. Currently, China constitutes just 2.5% of the MSCI All Country World index.

This separation between Chinese and international financial markets has had its advantages. Captive domestic capital enabled the country to invest for the long term, without the constant threat of capital flight. And international investors have been kept relatively insulated from the volatility in Chinese policy and markets.

But the segregation of China’s financial markets is increasingly becoming a thing of the past. As the country transitions to a consumer-led economy, its savings rate and trade surplus are declining. These changes contribute to a need for more foreign capital. As part of this drive, the government has made its exchange rate more flexible, and early this year unveiled a further 20 measures to reduce regulation on foreign investors.

Recently launched Stock Connect programs enable money to move between international Hong Kong markets and mainland Shanghai or Shenzen exchanges. Less stringent regulation on foreign-equity buying led index provider MSCI this month to again launch a consultation on including onshore A-Shares into its global equity indexes. USD 155bn of international money flowed into the Chinese bond market last year, leading major index providers Citi and Bloomberg to include China in their global indexes. And just this week authorities in Hong Kong and Beijing agreed to allow foreign investors to tap China’s onshore bond market through a new “Bond Connect” program.

As China’s financial system integrates with the rest of the world’s, I see three main consequences:

First, global investors will need to get used to monitoring China’s policy shifts. The country is trying to simultaneously tackle overcapacity and prevent growth from dipping below 6.5%. And if that isn’t hard enough, it is also trying to prevent sharp currency moves while keeping its more than 150% corporate debt-to-GDP ratio and USD 8.5trn shadow banking sector in check. This near-impossible juggling act inevitably means stop-start policy and volatility in interest rates, the yuan, commodity demand, and economic growth.

The weeks and months ahead will test China’s ability to keep these multiple balls in the air. Although the country has steadied its capital flows, credit growth is a cause for concern, and the government is now tightening policy. Shanghai interbank lending rates have risen 50bps year-to-date, monthly total social financing fell by more than CNY 700bn in April, and commodity markets are signaling a slowdown – for example, iron ore prices are off 6.5% in the past month. Thus far, global equity markets have taken the slowdown better than “China panics” in 2015 and 2016. Steadier capital flows have provided investors with more reassurance that China can manage its economy effectively this time around. We stay overweight global equities, but will continue to monitor China’s slowdown closely.

Second, the USD 5.1trn pool of Chinese domestic savings will increasingly influence global markets as hitherto constrained money seeks international diversification, and not just into South American soccer players. Even before the capital account has been fully liberalized, global investment from China into real estate totaled USD 33bn last year, a rise of more than 50% on the previous year. In equities, Stock Connect flows now account for around 9% of trading volume on the Hong Kong stock exchange. And the huge One Belt One Road project is gathering steam, with US 113bn (CNY 780bn) in overseas spending commitments revealed at a summit this month.

The Chinese yuan is likely to be on the wrong side of capital outflows from investors seeking international diversification. But investors who purchase assets likely to attract Chinese savings can benefit. For instance, we prefer stocks listed on the Hong Kong H-Shares market that trade at a discount to their equivalents on the Shanghai A-Shares market, as we see them as most likely to benefit from mainland investor flows.

Finally, investors will need to take a more active approach to managing portfolios. An economy in transition will create winners and losers. Since 2011 stocks exposed to “New China” have outperformed those exposed to “Old China” by 7.5% annually on average. As more index providers add China to emerging market and global indexes, investors will need to ensure their money is participating in China’s growth, and not merely equitizing its debt. The S&P New China and MSCI China indexes favor the growth parts of China’s market more so than the HSCEI and FTSE A50 indexes, which are weighted more heavily toward banks and resources.

All things are difficult before they are easy, and investors will need to be mindful of the kind of volatility China could provoke in the years ahead, as its influence on global investment markets grows to rival its effects on labor and commodity markets. Ultimately, this third wave should usher in positive changes and opportunity. Chinese investors will gain access to avenues of new investment around the world, while overseas investors will have the chance to participate in China’s transformation.

Tactical asset allocation

We keep a pro-risk stance in our tactical asset allocation, while making three adjustments this month:

We shift our overweight in US equities to global equities, versus high grade bonds. Though the outlook for absolute US equity returns is positive, and backed by double-digit earnings growth, the scope for US outperformance relative to the rest of the world has declined. After a strong run, US valuations are now at a 9% premium to the rest of the world, political uncertainty is rising, and the short-term soft patch in US economic data could lead investors to view other markets in a more favorable light.

Within Europe, we add an overweight in Eurozone equities relative to UK equities. A more stable pound, deteriorating economic data, and falling commodity prices are likely to weigh on UK earnings. Meanwhile, we think markets are likely to refocus on good Eurozone economic data and improving earnings growth, now that the immediate political risk has passed.

We shift our underweight in the Canadian dollar to the Swiss franc, relative to an overweight in the Swedish krona. Following recent depreciation, we close our underweight in the Canadian dollar in favor of an underweight in the Swiss franc. The franc is overvalued against most G10 currencies, and we believe it will see less safe-haven demand following the completion of the French election. The Swedish krona should be supported by strong economic growth and close-to-target inflation.

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