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Investment Insight: China is opening for business

Three considerations for investors in the region

It is no secret that China’s financial markets have gradually been opening up over the past decade. With the inclusion of domestic A-shares in MSCI’s emerging market indices this year, 2018 could potentially be a watershed year for the country’s growing influence on financial markets.

For now, this move is probably most important for its symbolism. China’s A-shares are often too fully valued for many Western investors to get excited about, and MSCI is only opening up its benchmarks to Chinese shares at a slow rate, in part because of governance concerns. But investors should not ignore the opportunities presented by China opening its doors.

Taking the time to understand this idiosyncratic market is worthwhile, even for investors not looking to allocate capital there immediately.

From my perspective, there are three broad areas investors need to consider; how the structure of China’s markets differs to more mature stock markets, the importance of Chinese retail investors and the role that the authorities play (or might play) in the market.

The structure of China’s markets can seem opaque. Broadly speaking, shares are divided into A-Shares and H-shares, depending on whether they are listed in mainland China or Hong Kong. Listing domicile also determines whether they are traded in Chinese renminbi or the Hong Kong dollar.

China’s markets are still opening up to the world, which can create interesting technical forces. The decision to connect the Shanghai and Hong Kong stock exchanges has allowed Chinese domestic investors to begin diversifying their equity exposure and invest in Hong Kong shares.

These “southbound” flows have been a strong support to the Hong Kong market over the past year. But, while the authorities want to open up, they are also cautious after witnessing intense market volatility at the time of the Chinese equity bubble in 2015.

In China’s domestic market the retail investor is a powerful force. This will change as China’s financial sector evolves and becomes more open. In the meantime, investors are very focused on the short term, tending to chase growth and push valuations up. When the momentum behind stocks or the wider market fades there will be the potential for volatility to pick up sharply.

Investors also need to understand the relationship between the state and the corporate sector in China. This can have an impact on how companies manage their balance sheets and their relative attraction for investors.

Last year, for example, China Unicom raised $11.7bn (£8.8bn) from investors such as Alibaba, Baidu and Tencent as part of the government’s push for state-owned enterprises to be rejuvenated with private capital. This is effectively cashflow leakage, whereby companies with strong balance sheets, like the Chinese internet names, are encouraged to support companies with weaker balance sheets.

So what next? It is clear that China’s relationship with markets will continue to evolve. While the authorities will probably become less interventionist over time, that process is unlikely to be smooth. Investors should be prepared for the risk of not being able to easily move their capital around or not being able to exit the country altogether — such as with a suspension in share trading, as we last saw in January 2016, or in the event of capital controls being imposed.

But these issues should not be blown out of proportion. We have seen official intervention to an unprecedented degree with QE in recent years and many developed market stock exchanges reserve the right to suspend trading.

China does face challenges in the short term, but it is not enough of a reason to write the market off just becuase the risks are unfamiliar.

For investors, including those like me who allocate to underlying managers, selecting the right active Chinese strategies is key. Long-term investors focused on valuations are perhaps particularly important here and a focus on tangible measures, such as company cashflows, can help to avoid governance risks.

Investors adopting this approach and being aware of the wider risks should benefit from the opportunity in China over the coming years.

Bill McQuaker is portfolio manager of Fidelity Multi Asset Open funds

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