China equities China bonds outlook What’s the 5-year expected returns for China equities and bonds?

China’s economy is rebounding after the COVID-19 outbreak but has the long-term outlook for China been impacted?

05 Oct 2020

Webinar: 5-year capital market expectations for China

For global investors with a 60/40 portfolio to equities and bonds, … adding a 5% allocation to Chinese assets … will increase expected 5-year returns and the Sharpe ratio, while slightly decreasing volatility.

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

Integration of China within global financial market

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.

Put together, these factors have significant meaning for investors:

  1. domestic investors are increasingly looking to allocate to financial assets, creating huge demand for investment vehicles and new opportunities;
  2. we are seeing much stronger demand from foreign investors for Chinese assets.

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Perspectives matter. Tune in to our insights.

Foreign investors’ ownership of onshore China stock and bond markets is still low

Source: Bloomberg, Wind, UBS estimates; data as of June 2020

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.

Future shift in Chinese household wealth to equities, bonds and fundsAllocation of Chinese household wealth

Source: CICC June 2020, UBS

Capital market assumptions, Aug 2020-Aug 2025

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.

In CNY Terms

Asset Class

Geometric
Return

Standard
Deviation

Sharpe
Ratio

Cash[1]

2.0%

1.3%

0.00

China Government Bonds

3.0%

4.6%

0.31

China Policy Bank Bonds

3.3%

4.2%

0.41

China Corporate Bonds

3.4%

4.7%

0.38

Chinese Equities

8.9%

21.5%

0.45

Global Equities

7.8%

16.7%

0.42

Inflation

2.5%

N/A

N/A

In USD Terms

Asset Class

Geometric
Return

Standard
Deviation

Sharpe
Ratio

Cash[1]

0.3%

1.3%

0.00

China Government Bonds

1.2%

4.6%

0.23

China Policy Bank Bonds

1.5%

2.7%

0.50

China Corporate Bonds

1.7%

4.7%

0.32

Chinese Equities

8.9%

22.9%

0.50

Global Equities

7.2%

16.0%

0.50

Inflation

1.4%

N/A

N/A

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.

Chinese equity returns and currency perspectives

 

CNY

USD

EUR

CHF

China Equity Local

8.9%

8.9%

8.9%

8.9%

Local Market return

8.9%

5.9%

8.1%

7.2%

Unhedged currency impact

 

0.0%

-0.7%

0.4%

Total return unhedged

 

8.9%

8.2%

9.3%

Hedged currency impact

 

-1.7%

-2.6%

-2.8%

Total return hedged

 

7.2%

6.3%

6.1%

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

60/40 Portfolio

Asset class

Asset class

Starting Portfolio

Starting Portfolio

Add 5% to Chinese Assets

Add 5% to Chinese Assets

Asset class

Developed Market Equities

Starting Portfolio

55.0%

Add 5% to Chinese Assets

55.0%

Asset class

Emerging Markets x China Unh

Starting Portfolio

5.0%

Add 5% to Chinese Assets

2.5%

Asset class

China Eq Unh

Starting Portfolio

0.0%

Add 5% to Chinese Assets

2.5%

Asset class

Global Aggregate Hedged

Starting Portfolio

40.0%

Add 5% to Chinese Assets

37.5%

Asset class

China Aggregate Hedged

Starting Portfolio

0.0%

Add 5% to Chinese Assets

2.5%

Asset class

Total

Starting Portfolio

100.0%

Add 5% to Chinese Assets

100.0%

Asset class

5-Year Expected Return

Starting Portfolio

4.2%

Add 5% to Chinese Assets

4.3%

Asset class

Standard Deviation

Starting Portfolio

10.3%

Add 5% to Chinese Assets

10.2%

Asset class

Sharpe Ratio

Starting Portfolio

0.43

Add 5% to Chinese Assets

0.44

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.

Q&A

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.

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