China is at the center of a second rebalancing process that will transform China’s financial sector, shift global asset allocation to China, and reflect China’s weight in the global economy.

China is moving from the old state-directed financing model to a system with a more diversified range of credit channels that both allows foreign capital to play a greater role and relies more on market-based principles. Opening up to foreign capital is a fundamental part of this. China has made huge steps in recent years by making its equity and fixed income markets fully accessible to global investors following the opening of the Stock and Bond Connects.

The process of rebalancing global asset allocation to China has started, with the shift to onshore assets picking up on both equity and fixed income markets. By the end of September 2018, overseas investors’ onshore holdings of equities and fixed income were up 25.2% and 58.0% y-o-y¹, respectively. The index inclusion processes will accelerate this trend.

Overseas investors’ onshore China holdings (RMB trillions), January 2016 – September 2018

Equities and fixed income benchmark providers have started bringing onshore assets into their global benchmarks to more fully reflect Chinese markets, and they are anticipated to bring in an estimated USD 300 billion² of inflows over the next 10 years.

As these trends play out, investors will have to become aware of the many attractive opportunities in China’s onshore markets, with equities and fixed income standing out.

While 2018 has been as challenging year, data from previous periods show that key China equity benchmarks have performed well.

Our calculations show that average returns on the main Chinese equity benchmarks compare well with other global benchmarks, albeit with much higher volatility.

Global equity benchmarks – return, volatility, October 1, 2005 – November 30, 2018 (USD)

Access to onshore markets gives investors a wider choice of companies in fast-g rowing ‘new economy’ sectors, like consumer discretionary, IT, healthcare, and insurance, thus offering a wider set of growth opportunities than currently available offshore, like in Hong Kong and US equity markets, where some Chinese companies are listed.

But beyond returns and access, onshore China equities offer valuable diversification benefits to investors, since Chinese equity markets have low correlation to global markets, because they are more focused on growth opportunities in China, where growth trends differ markedly.

And by historical standards, China equity valuations on A-share markets look attractive. Trading at 10.9x P/E at the end of September 2018, valuations are low, particularly when considering fundamentals for ‘new economy’ sectors look attractive.

MSCI China A vs. MSCI China (No. of companies), November 2018

Correlations between global equity indices, February 2002 – September 2018 (USD)

10yr government bonds (nominal yields), January 1, 2013 – November 1, 2018

12M forward P/E ratios, September 2018

But China equities come with volatility. Though a challenge, this actually represents opportunity for experienced active managers with detailed sector knowledge, rigorous research practices, and a nose for on-the-ground conditions.

China’s equity volatility comes in part because the market is retail-driven. This is one aspect that we expect will reduce over time as more long-term, institutionally driven capital enters the market, but still represents an opportunity for active managers with the knowledge and research capabilities to identify and take advantage of mispricing.

On-the-ground research makes a difference here. Drilling down into China’s markets, visiting companies, surveying customers and suppliers, helps build a true picture of corporate quality, which is particularly valuable in China’s retail investor-driven market.

While it has been a challenging year for China equities, it has been a standout year for local-currency China fixed income, which has delivered outstanding returns compared with other major markets so far into 2018.

And that is on top of China fixed income offering some of the best yields currently available on global markets, a trend that will continue given China’s ongoing efforts to keep monetary policy tight and pursue a deleveraging agenda.

China’s bond market is in a rapid growth period, sparked by reform. Investors have typically put their capital into housing but the Chinese government has been opening up the bond market as an alternative investment channel, thus moving the emphasis away from bank-led financing to the economy.

This factor, combined with opening the bond market as a source of local government financing, and as an option for international investors, is putting the Chinese onshore bond market on track to overtake the Japanese market and emerge as the second-largest in the world by 2020³.

Local currency bonds total return YTD, December 31, 2017 – November 13, 2018

Market reforms, like the opening of the Bond Connect and the China Interbank Bond Market, as well as regulatory changes, like imposing tougher standards on domestic credit ratings agencies and opening the market to overseas ratings agencies, mean index providers are steadily putting onshore bonds into their benchmarks.

These structural trends are compelling, but onshore fixed income offers a series of highly attractive benefits to investors – too strong for global investors to ignore. From a return perspective, onshore China bonds offer decent return and relatively low-risk compared to other global bond benchmarks.

Additionally, onshore fixed income offers diversification benefits compared to other global indices, giving investors protection against global market headwinds.

Global bond statistics, October 2005 – September 2018 (USD)

Correlations between global fixed income indices, February 2002 – September 2018 (USD)

Put together, China’s efforts to open up its stock and fixed income markets amount to a concerted effort to reform its financial sector. These reforms will improve efficiency and credit allocation by bringing in foreign banking expertise, make the market more investible by increasing the influence of longer-term institutional capital, and opening up new funding channels for domestic businesses.

As these processes play out, there will be attractive opportunities for equity and fixed income investors, where standalone investments in the two asset classes offer excellent prospects from a return and diversification perspective.

But China remains a challenge for investors, because rules can be opaque and markets volatile. Given this reality, taking an active approach with a well-resourced local team and an on-the-ground network can help investors navigate markets and position accordingly.

¹ People’s Bank of China, November 1, 2018
² UBS Asset Management, June 17, 2018
³ UBS Asset Management, Bloomberg, September 30, 2018