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Chinese Markets Primed to Shine as Coronavirus Outbreak Fades

Summary

Once the coronavirus outbreak is contained and business returns to ordinary operations, the Chinese market will continue to offer the unique opportunities that originally attracted global investors. With patience and an opportunistic approach, investors will discover a wealth of new opportunities to leverage the Chinese market’s low sensitivity to the global market and build a more diversified investment portfolio.

With all the discussion of the coronavirus and its impact on the Chinese economy, we at The China Guys wanted to explore two secular investment themes that are still valid in these trying times – market liberalization and risk diversification. Although investment outlooks on China are in flux, these two trends were important before the coronavirus outbreak and will remain important after it subsides. China’s rise may have hit a bump in the road, but after the dust settles, it will continue to offer the unique opportunities that originally attracted global investors.

Market Liberalization

When Deng Xiaoping began the Opening Up and Reform movement, he could never have imagined the change he set in motion. He declared in 1985 that “reform is the only way for China to develop its productive forces.” The new special economic zones and other progressive economic measures generated an unprecedented deluge of capital that distanced China from its isolationist past. This development gained momentum and significantly contributed to China’s rapid economic growth in the last 35 years. Today, these market liberalizations are taking on new forms and adaptations which are creating both opportunities for investors and tensions with governments across the globe. At its core, the US-China trade dispute debates the speed, direction, and extent of Chinese market liberalization. For the latest updates on the US-China trade negotiations, see our analysis of the US-China Phase One trade deal.

Deng Xiaoping with Gerald and Betty Ford

Figure 1: Deng Xiaoping with Gerald and Betty Ford, 1975 (Gerald R. Ford Library)

To see the continued progression of the opening up and reform movement in the Chinese market, look no further than the finance industry. Historically, the Chinese government has forbidden majority foreign ownership investment in three subsectors of the Chinese financial system: (1) securities, (2) futures, and (3) life insurance. According to the negative investment list, where the Chinese government outlines industries in which foreign investors cannot invest, these three core financial sub-sectors will open to full foreign ownership by 2021. Moreover, these are currently the only three remaining finance industry restrictions explicitly stated on the negative investment list.

Financial infrastructure is an enabler of global business and generates second- and third-degree effects on knowledge and capital flows in and out of China. More specifically, major global investment banks, insurance companies, and asset managers may now have unprecedented access to the Chinese financial market as well as enhanced control over their Chinese operations. In turn, these financial intermediaries would be able to better serve clients globally by offering a full-suite of fully owned services that may lessen the burden of foreign firms operating in China and encourage Chinese firms to expand outside the borders of the Middle Kingdom. Global financial systems and infrastructure will lay the groundwork for future economic growth and cooperation.

Risk Diversification

Diversification is crucial for maximizing risk-adjusted returns for an investment portfolio. Diversification reduces the overall risk of an investment portfolio by allocating capital across a basket of asset classes and geographies to contain the impact that a single event has on the aggregate performance of a portfolio. For example, many people spread their retirement investments between stocks and bonds in order to increase diversification and reduce risk. From the perspective of geography, investors can also spread their capital across different countries to diversify risk. 

According to Bridgewater Associates, the world’s largest hedge fund, Chinese market investment provide the benefit of diversification for international investors due to: (1) the primacy of the domestic market, (2) the independence of monetary policy, and (3) the differentiated equity market investor pool.

Primacy of the Domestic Market

Investing in China could help an investor diversify as “companies listed on the [Chinese] A-share market derive 86% of their revenues from inside China and only 14% from abroad.”  This high concentration of domestic sales reduces Chinese companies’ sensitivity to global markets. In contrast, US and European public companies derive 29% and 45% of revenue from outside their borders respectively. As Chinese markets may offer rewards in times that other markets perform poorly, an investor that holds a basket of investments across the US, Europe, and China will benefit from diversification and may outperform a purely domestic portfolio of the same risk level.

Independent Monetary Policy

China’s central bank maintains independent monetary policy. Because the central bank restricts the flow of funds in and out of China, its control of interest rates and exchange rates is quite comprehensive. Compared with the United States and Europe, China’s currency market is relatively closed, providing much more control over interest rates and exchange rates, which in turn affect the domestic equity market. An open currency market is a double-edged sword – it allows free capital flows and market-driven currency pricing but also reduces the ability of the central bank to intervene in economic crises. If the current market downturn snowballs into a global recession, China has more monetary policy tools than the developed markets, especially those with negative interest rates, to blunt the effects of the recession. China’s controlled monetary policy contributes to Chinese markets’ relatively low correlation with the global market.

Equity Market Investor Pool

The third driver of diversification and investment opportunities in China is distinct differences in equity market investor groups. Figure 2 shows that retail investors control most of the Chinese market capitalization (67%). Europe and the United States favor institutional investors such as pension funds, mutual funds, and broker-dealers. Due to different investment objectives, strategies, and methods between these two types of market participants, China’s equity market behaves differently. Bridgewater Associates assert that retail investors are more inclined to invest in trends and move “with the herd.” Conversely, institutional money managers often use equity research to pick unpopular stocks with significant upside potential. Overall, the Chinese equity market ownership structure contributes to low correlation with global markets and opportunities for institutional investors in China.

Equity Market Ownership Across Three Major Markets

Conclusion

The coronavirus outbreak is shaking global markets to their core while inducing widespread volatility. However, once this outbreak is contained and business returns to ordinary operations, we at The China Guys believe China will continue introducing measures to open its markets to the outside world. With patience and an opportunistic approach, global investors and financiers will discover a wealth of new opportunities to leverage the Chinese market’s low sensitivity to the global market and build a more diversified investment portfolio. 

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