2 juin 2017

The China Anomaly

June 2, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)

Over the last month, a very rare performance anomaly has developed on the Chinese equity market. The 50 largest (A-share) stocks included in the Shanghai SE Composite Index (SSE), China’s primary stock exchange, have considerably outperformed the broader benchmark index (see Figure 1). Typically, large blue-chip stocks move almost in complete sync with the wider market (see Figure 2). On top of that, the MSCI China appreciated faster than the SSE, too. To be clear, a double divergence is an extremely rare event. What are the potential underlying sources of this anomaly? And what does the anomaly mean for investors?

A Double Divergence

In order to better visualize the anomaly, please skip through Figures 1 to 5 in quick succession, just like a comic book. You should notice three things stand out. One, the notable short-term outperformance of the FTSE China A50, an index of the country’s 50 largest A-share stocks, gradually disappears as the time window widens. Over a 10-year window you can barely notice it anymore; the SSE and FTSE China A50 are essentially the same. Two, the MSCI China index, another broad equity index covering another set of stocks than the SSE, evolves rather independently, typically outperforming its peers. Only for a brief period around the 2015-16 stock market bubble the picture reverses (see Figure 4). Three, a considerable double divergence––i.e. the FTSE China A50 and MSCI China simultaneously deviating from the SSE––is almost unheard of.

The Chinese Stock Market

Compared to a ‘typical’ developed country, the Chinese stock market is much more fragmented with many restrictions on investor participation. Table 1 illustrates the most important characteristics (sources: FTSE Russel « Guide to Chinese Share Classes », FTSE China A50 and MSCI China index definitions). These features have important implications for our analysis because the earlier introduced indices cover different types of shares. The SSE focuses on the A and B shares market segment covering mainland Chinese companies. The FTSE China A50 index universe selects the largest 50 companies among all A share stocks. Thus, it represents the large cap segment of the SSE. The MSCI China takes quite the opposite approach by concentrating on Chinese companies whose principal business interest is on the mainland but whose stocks are trading off-shore, notably in Hong Kong or in the US.

The Anomaly in Context

These deliberate choices have tremendous influence on the underlying portfolio each index represents (see Table 2). For instance, the FTSE China A50 (and the SSE by extension) is dominated by a handful of mostly financial companies. The top 10 constituents even account for nearly 50% of the large cap index. By contrast, the MSCI China reflects a wider range of industries, such as technology, financial or consumer stocks, although being still more concentrated in terms of the number of constituents. A mere ten out of 150 stocks make up about 55% of the entire market capitalization.

The above information provides relevant perspective with regards to the underlying trends behind the anomaly. Table 3 summarizes our thoughts. The way we see it, the size of the average index constituent and the type of investor is what distinguishes the FTSE China A50 from the SSE. The former characteristic may hint towards a divergence of large cap stocks from their small and mid-cap peers. The latter points to the possibility that systematic buying of institutional investors, say via futures, shores up liquidity for a distinct segment of the overall market thereby supporting price divergence.

When comparing the MSCI China and SSE, we identify differences that are more structural in nature. With a stronger emphasis on technology stocks the MSCI China arguably offers better long-term growth prospects. Owing to their offshore listings, stocks included in the index further need to comply with stricter listing requirements thus improving corporate governance and reducing harmful political interference at the same time (although political influence cannot be entirely ruled out, of course). The fact that most index constituents are private businesses rather than state-owned enterprises (SOE) further corroborates this point.

Therefore, we suspect that the recent underperformance of the SSE most likely reflects a small and mid-cap discount possibly amplified by institutional investor purchases (FTSE China A50 vs SSE). And indeed, small cap stocks have enjoyed considerably smaller returns than their peers over the last year (see Figure 6). On the other hand, the long-standing underperformance of mainland Chinese companies vis-à-vis their offshore peers (MSCI China vs SSE) appears to be more closely linked to institutional obstacles on the mainland such as weak financial regulation, political intrusion and poor corporate governance. Hence, the observed anomaly depends on a combination of widening spreads on small cap stocks and institutional weakness.

The Stock Market and Its Fundamentals

So far, we have ignored the relevance of China’s political and economic cycles for the stock market. The political cycle is dominated by the ruling Communist Party’s (CP) 5-year election cycle. The CP frequently seeks to suppress any form of social and economic uncertainty in the run-up to major party events such as its party convention. In addition to other macro factors, political interventions into China’s still highly regulated economy are therefore one of the key determinants of business life.

This fits well with the long-term outperformance of the MSCI China over its mainland rival. While maintaining their primary business interest on the mainland, companies incorporated in Hong Kong were subject to the same economic cycle but managed to escape some of the political intrusions and impediments their domestic competitors had to face. Hence, they over-proportionately benefitted from China’s rapid growth over the last decade (see Figure 6).

Moreover, major political interventions seem to repeatedly profit ‘foreign’ Chinese companies more than mainland firms. When the government decided to massively raise debt to respond to the Great Recession, the corporate sector, including many SOEs, followed suit (see Figures 7 and 8). As a result, China has built up the same level of indebtedness in less than 20 years the US accumulated over more than seven decades! Most of this new debt now sits in the corporate sector. Then, in early 2016, the central government ramped up short-term stimulus via SOEs to stabilize a cyclically slowing economy. More than a year later, private fixed asset investment growth still lags its public equivalent by a wide margin (see Figure 6). Yet, on both occasions, the MSCI China outperformed the SSE.

Moving closer to today, the country finds itself in a delicate economic and political situation (see Table 4). On one hand, the economy seems to enter a new phase of deceleration as numerous indicators have fallen below their recent peaks (see Figure 9). On the other hand, with the CP summit approaching in November 2017, earlier efforts to overhaul the economy, reduce the reliance on new debt or reign in corruption have been mostly put on hold. To ensure a smooth summit the government relies on the unconditional support of public officials. The few changes that were implemented, however, were mostly contractionary in nature.

Both factors, a softer economic expansion and stricter regulations, favor large companies, most of them SOEs. Their larger size and government backing helps them to secure funding more easily. Their supra-regional and cross-industry reach further diversifies inherent business risks. Lacking these advantageous, small companies struggle to keep up with the ‘big shots’. This is why, in our view, the FTSE China A50 has beaten the SSE.

What’s Next

Unless the Communist Party decides to seriously take on the challenges small mainland Chinese companies face, they will find it hard to compete with their larger or ‘foreign’ Chinese rivals. Hence, we believe the detected extreme anomaly hints to a serious divergence within the Chinese economy. The primary beneficiaries of these frictions are companies included in the MSCI China given their stronger growth prospects and higher political independence. Investors seeking an exposure on the mainland should ensure they keep a large cap bias, such as the FTSE Chine A50. For the time being, the SSE offers the poorest growth prospects.

Figure 1: 1-Month Performance of Shanghai Composite, MSCI China and FTSE China A50

Figure 2: 6-Month Performance of Shanghai Composite, MSCI China and FTSE China A50

Figure 3: 2-Year Performance of Shanghai Composite, MSCI China and FTSE China A50

Figure 4: 3-Year Performance of Shanghai Composite, MSCI China and FTSE China A50

Figure 5: 10-Year Performance of Shanghai Composite, MSCI China and FTSE China A50

Figure 6: 1-Year Performance of MSCI China and MSCI China Small Cap

Figure 7: China Fixed Asset Investments by Category, YoY%

Figure 8: Chinese and US Total Debt-to-GDP in Historical Perspective

Figure 9: China Historical Debt-to-GDP Ratio by Sector

Figure 10: Chinese Manufacturing PMI, Monetary Conditions Index, Producer Price Inflation and House Price Growth

Table 1: Summary of Share Class Characteristics

Table 2: Top 10 Holdings of the FTSE China A50 and MSCI China

Table 3: Summary of Key Features by Benchmark Index

Table 4: Commented Comparison of Expected Long-Term Trend and Recent Experiences

Published on Riskelia’s Blog