China: Five year capital market expectations and boots-on-the-ground insights

Dr. Louis Finney, PhD, Co-Head of Strategic Asset Allocation Modeling, Investment Solutions

Max Luo, Director, Investment Solutions

China is in a strong starting position. It has got through the pandemic first and its growth rate has picked up before other Western and emerging markets.

Although growth will moderate compared to the past twenty years, we still expect future growth to be well above the developed markets and offer opportunities to investors. 

Additionally, China has higher nominal and real interest rates than in developed markets.

We are seeing continued integration of China within global financial markets. Although tensions between the US and China have provided some hiccups, we are seeing continued opening of China’s capital markets to foreign investors, and China’s equity and bond markets are steadily being included into the major global indices.

Foreign investors’ ownership of onshore China equity and stock markets (%), Jan 2015-Jun 2020

Put together, these factors have significant meaning for investors. First, domestic investors are increasingly looking to allocate to financial assets, creating huge demand for investment vehicles and new opportunities. Secondly, we are seeing much stronger demand from foreign investors for Chinese assets.

Looking into the next decade we expect that growth will moderate, mainly because of China’s aging population and the shrinking labor force.

That said, we do see support for the outlook. Firstly, we see productivity gains from the increasing quality of China’s labor force as well as the expansion of technology through both the manufacturing and services sector.

Additionally, we expect the rebalancing of the economy to consumer-driven growth and the growth of the middle class will propel Chinese activity in the future.

We believe the growth of the middle class, plus continued capital reforms, will result in a marked shift in asset allocation away from real estate and deposits and into public equities, bonds, and funds.

Allocation of Chinese household wealth

On the cash and fixed income side, we project geometric returns of 2%-3.5% in CNY terms over the next five years. 

For Chinese equities, we project annualized returns of 8.9% in CNY terms between August 2020 and August 2025, albeit with higher volatility than for the global equity market.

Capital market assumptions, Aug 2020-Aug 2025

[1] 1-month Treasury bills
Notes: Fixed income in USD terms are hedged. Chinese equities in USD terms are unhedged. Global equities are unhedged in both CNY and USD terms.
Source: Bloomberg, Wind, UBS estimates; data as of August 2020

Comparing our China equity projections to other global markets, we see stronger returns compared to those available in the US, Europe and Switzerland over the next five years. In unhedged terms, we expect China equities will also outperform the three markets considered.

Looking at the fixed income side, we expect annualized returns of 2.9% in CNY terms over five years for 10-year Chinese government bonds. 

Looking across seven major global markets, our expected annualized returns over five years for hedged 10-year Chinese government bonds are superior to those available for local bonds in all markets considered.

Expected 5-yr returns from hedged 10-yr bonds

How do these assumptions affect portfolios?

Looking firstly at correlation, we expect the correlation of Chinese equities with the S&P 500 to stay lower than the correlation we see of US equities with the other developed markets. For fixed income, we are expecting correlation to be even lower than for equities, which is very promising for investors who are building global portfolios.

For global investors with a 60/40 portfolio to equities and bonds, we estimate that adding a 5% allocation to Chinese assets, with 2.5% to equities and 2.5% to bonds on an unhedged basis, will increase expected 5-year returns and the Sharpe ratio, while slightly decreasing volatility.

Diversification Benefits from USD Perspective

In summary, we view China as a very unique economy and it is neither an emerging market nor a developed one. We think that adding Chinese assets should improve the Sharpe ratio on a forward-looking basis and lower volatility, particularly from a fixed income allocation.

Denise Cheung, Analyst, Equity Specialist, Global Emerging Markets Equities and Asia Pacific Equities

We are long-term investors and that means we are always looking forward to future opportunities. 

Since the consumer sector is one of primary areas of focus, we pay attention to new groups of consumers and their behaviors. Focusing on these groups gives us a sense of how the consumer sector will evolve and which companies are best placed to cater to them. 

Currently, the main group of consumers are those born in the 1970s and 1980s. But the new generation born in the late 1980s and 1990s are becoming the mainstream consumer group in China.

These ‘Generation Z’ and Millennial groups made up 40% of the total consumer base in 2019. Importantly, these groups grew up as China’s economy surged, living standards improved, and internet access widened.

That’s significant for a couple of key reasons. Firstly, these generations are spenders rather than savers, largely because we believe they are more optimistic about the future than elder generations. Secondly, they grew up with the internet, spend a lot of time online reviewing, comparing and purchasing products, and can quickly accept new innovations.

% of Age Group

Compared to their parents, these younger generations are more influenced by information in the virtual world and are more inclined to spend online, and we expect they will become they will become the mainstream consumer group over time. 

Additionally, most online shoppers in China are located in first-tier cities, like Shanghai and Beijing, meaning that online penetration in lower-tier cities remains low and has space to grow. So as younger consumers become mainstream and online shopping expands into lower-tier cities, we expect that China’s e-commerce sector will continue to grow in the future.

Source: Emarketer, 2019
Size of the bubble is for illustrative purpose only

Online feedback is one of the key factors when making a consumption decision, others include quality and brand image. In this context, livestreaming is becoming one of the most popular ways to stimulate consumption in China.

Livestreaming combines the experience of shopping, socializing and entertainment into an online show broadcasts directly to viewers.

In the broadcasts, hosts and key opinion leaders give live product reviews, make recommendations, and interact with viewers. Importantly, these shows give viewers confidence in products and help drive sales. For example, iMedia estimates that livestreaming broadcasts generated USD 61bn of sales in 2019, and sales may double in 2020 as livestreaming become even more popular under the pandemic.

COVID-19 has changed many aspects of daily life across the globe, including China. More specifically, it has accelerated behavioral changes in a matter of months that usually take years.

For example, students are studying online, workers are working from home, and online gaming and shopping has become increasingly common.

For investors, it is now increasingly important to have the foresight to anticipate future behavioral changes to be positioned appropriately to capture these changes. In this context, bottom-up, on-the-ground research in China is more important than ever.

Max Luo (ML): When I walk around Shanghai, it feels like things are back to normal. Looking at official data for the whole economy, most indicators are now either back to or higher than their pre-COVID-19 levels.

Louis Finney (LF): I would expect that either administration that comes in next January will have some tension with China. In the short run, there will be ups and downs with the relationship, and that’s why we have built in political risks into our expectations and why we expect to see some volatility in the outlook for China assets classes. 

But when we look to the longer run outlook, we see trade tensions as a temporary issue, and expect there will be gradual integration of China into the global economy, and we believe that’s what long-term investors should really be focused on and thinking about.

ML: In the near-term, I don’t think China is in any mood to escalate matters with the US. I see the Chinese government in ‘relationship management’ mode with the US and other Western democracies.

For example, despite many Chinese companies being put on the US ‘entity list,’ China has waited a long time to issue a list of its own and has not specifically issued any names of US companies so far. 

Ultimately, we see China responding with further reforms to open the economy. China has recently accelerated the pace of economic reforms and financial market opening, such as allowing foreign companies to take majority stakes in domestic financial services companies.

Denise Cheung (DC): Our approach is very much driven by bottom-up research, we want to pick the stocks that will do well in the long run no matter the market cycle or geopolitical environment.

In general, our China equity portfolios are focused on companies that are driven by domestic factors. Additionally, we are very selective about the companies we put into the portfolio.

LF: We expect China’s share of the major indices to increase over time, and that may raise the level of correlation with global markets.

However, I don’t think this correlation will rise to the level seen between developed markets. China is such a unique economy with its vibrant tech sector, capital markets opening, and huge population that it's going to have its own cycle, which will be distinct compared to the rest of the world. 

MC: We expect inflows to climb as the markets go into global indices. That ultimately means retail investors will become less influential in the market and longer-term institutional investors more prominent.

DC: With regard to Tencent and Alibaba, their overseas exposures are actually quite small and growth is primarily driven by the domestic market in China.
Looking at the tech hardware space, it is evolving rapidly with innovation cycles having a very short timeframe. 

So far this year, the sector has done very well. The reason for that is that investors expected China’s government to support tech hardware companies because of geopolitical tension. 

Currently, it is hard for us to see a clear leader in the tech hardware space and valuations have rerated significantly after the recent rally so we are taking a prudent approach to investing in this sector.

DC: We believe that the rally is well-founded from a fundamental perspective. 

The companies that have performed well in the rally have not been so heavily impacted by the COVID-19 outbreak and are relatively domestically driven and thus largely protected from US/China trade tensions. 

This is a very different situation to the rally in 2015. At that time, we saw a lot of investors putting money into the market without much attention to fundamentals, and the equity market crashed in the second half of the year. 

For now, liquidity in the market has played a part in the rally, and we have taken a cautiously optimistic approach. We remain positive on the long-term prospects for investing in China and see many good quality companies in the market.

However, we do see some volatility in the short-term ahead of the US election, so that’s why we are keeping some dry powder available to take advantage if market volatility presents buying opportunities.

LF: For a hypothetical 60 equities/40 bonds global investor, a 5% weight to equities and bonds, close to what the global benchmarks have currently, is a terrific starting point. 

With a separate allocation to China, an investor has a great lever from a tactical asset allocation perspective because of the low correlation and growing liquidity within China’s markets.

Starting from a 5% level, maybe moving up to 10% at very opportunistic times, and down to 2% when we feel markets are overvalued, is a good starting point for a truly global investor.

DC: ESG has always been a very important factor when we evaluate companies. We are long-term investors so we take a rigorous approach to ESG issues in our bottom-up research and assessments.

We have monitored Chinese companies for years and their standards have definitely improved. This became particularly obvious after the launch of the Stock Connect program in 2014. 

Stock Connect put Chinese companies under greater scrutiny from international investors, so they had to bring their standards in line with global levels.