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China’s onshore
equity markets
The next big thing in emerging markets

FOR PROFESSIONAL, INSTITUTIONAL,

WHOLESALE AND QUALIFIED INVESTORS/
PROFESSIONAL CLIENTS ONLY

MKTG0518U-484019-1565418

Jeff Shen
Co-Chief Investment Officer,
Scientific Active Equities (SAE)
Summary
• In recent years, equity markets in China have lagged
behind the spectacular growth of the economy.
• Various structural constraints made onshore equity markets
relatively inefficient, while investment-led growth left little
cash to distribute to shareholders.

• Now, with the government pushing to liberalize the

economy and shift to consumption-led growth, equity
markets may be entering a new phase.

Rui Zhao • Financial liberalization and the upcoming inclusion

Lead Portfolio Manager,
of China A-Shares in MSCI indexes may improve the
SAE China
sophistication and efficiency of Chinese equity markets,
potentially making them a more attractive investment
proposition for global investors.

• Reform efforts face significant hurdles, however, including

the excessive growth of leverage and a credibility deficit
Gerardo Rodriguez after meddling with equity markets and mismanaging
Senior Portfolio Manager, exchange rate policy in recent years.
SAE Emerging Markets
• Even considering its challenges, we believe China has
several structural advantages that may continue to support
above-average growth over the medium term.

• A better functioning onshore equity market may benefit

significantly in the coming years from the relatively fast
Gerald Garvey
pace of economic activity.
Head of Research, SAE Asia Pac

Contents • Chinese equity markets, still broadly untapped by

global investors, may become more attractive because of
Introduction....................................3 these trends.

Economic rebalancing..................4

Macroeconomic challenges.........6

Reform agenda and

investment opportunity...............7

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Introduction
Conventional wisdom says that when a country prospers, its
equity market should do well. Empirical evidence supports
the idea that economic growth is associated with strong
equity market returns (see the Economic context chart). The
correlation of GDP growth with equity market returns has
been historically around 0.5.
Economic context
Equity returns and GDP growth, 2000-2017
over the past 20 years, the economy may have experienced
the greatest growth in history, but the equity market was
little changed, notwithstanding a significant expansion in
corporate earnings (see the China discrepancy chart).
The China discrepancy
Equities vs. corporate earnings and GDP
900

Index level: 2000 =100

Earnings
7%
600
GDP
China
6
300

5 IND Equity index

0
Annual GDP growth

RUS
4 2002 2006 2010 2014 2018

Sources: Haver, CEIC and Bloomberg, March 2018.

3
Notes: The chart displays the Shanghai Stock Exchange A-share Index 6-month moving
average, China GDP growth and China corporate earnings growth, all normalized to 100
beginning in year 2000.
2 BRA
COL
ZAR China’s path to prosperity is getting more challenging,
UK
1 US especially given the excessive amount of leverage in the
CAN MX economy, as we explained in the BlackRock Investment
0 Institute’s 2017 publication “China’s Tricky Transition.”
0 2 4 6 8 10 12 14 16% Moving toward a market-based economy is never easy and it
will take many years to reduce the prominence of state-owned
Annual equity returns
enterprises. China will also have to restrain the government
impetus to interfere in financial markets and deal successfully
Source: Bloomberg, IMF, December 2017. Equity returns are represented by the MSCI equity with excessive debt burdens accumulated in recent years.
index for each country.

Notwithstanding these challenges, we believe China will

This correlation makes intuitive sense. Over long periods,
continue to show above-average economic growth over
the returns of an equity market are often determined by
the medium term, and due to several structural factors
the earnings growth of the companies listed on the market.
that we describe in this paper, may also start delivering a
Their earnings growth, in turn, is usually closely connected
stock market performance that is better aligned with the
with GDP growth.
economy. We expect performance to be driven by financial
market integration and the ongoing economic rebalancing
However, that transmission mechanism has been far from
in favor of domestic consumption, which are occurring after
perfect, and for shorter horizons it has been much weaker.
a long period in which Chinese equity valuations have been
There are also cases in which economic growth and corporate
converging down to the levels of other emerging markets.
earnings outstrip stock returns over reasonably long time
horizons. Particularly striking is the case of China, where,
T H E NE X T BI G T HI NG I N E ME R GI NG MA RKET S 3

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Economic rebalancing
It is no secret that the Chinese economy and its growth have
become dominant factors in the global economy. In a sense,
China is regaining the global prominence it enjoyed before
the industrial revolution. During that period, the world was
predominantly poor and the most important economies were
those with the largest populations. With prosperity becoming
widespread globally, we are going back to the future (see the
Back to the future chart).
The rapid pace of Chinese economic activity has become
particularly striking in a period of low global growth. China
is now the most important contributor to global economic
activity, accounting for nearly a third of total global economic
growth, according to 2018 IMF data. More importantly, the
composition of this growth is shifting away from investment
toward consumption. This trend, which started in 2010, is part
of the policy framework for the future that authorities have laid
out. The objective is to put the Chinese economy on a more
sustainable medium-term path.
The economic shift from investment to consumption will be
crucial for China’s stock market performance going forward.
In financial statement terms, an investment-led boom implies
that profit growth is disproportionally driven by the growth of
corporate balance sheets.
We have known for years that this situation, characterized
by divergence between earnings and free cash flow, is not
necessarily a good thing for equity market returns. But as
consumption becomes a more important component of
overall growth, earnings quality tends to improve. Just like
in other advanced economies, this can lead to a larger
generation of free cash flow by Chinese corporations.
Evidence shows that in China, the aggressive economy-wide
capital formation has been mirrored in the corporate world.
The key is the wedge between operating cash flow and
investment. In the U.S. there has been a systematic surplus
of cash flow over and above investment. In China, this has
not yet been the case as the impressive growth in earnings
was essentially fully absorbed by investment (see the Where
the Cash is Flowing chart on the next page).
Rewards to shareholders have been further diminished
by the dilution of per share earnings via the issuance of
new equity. But as investment tails off, less equity issuance
will occur and more free cash flow will be available for
distribution to shareholders. In the U.S., a more mature
corporate sector has been throwing off significant free cash
flow and making net distributions to shareholders since the
restructuring wave of the 1980s.

Back to the future

Global GDP composition by country, 1AD-2016

100%
World GDP Composition

75
Others
Mexico
Others France
50 Brazil
France
UK UK
Italy
Italy Germany
25
Germany U.S.
China China
0
1000

1500

1600

1700

1820

1870

1900

1950

1960

1970

1980

1990

2000

2008

2014

2017
1AD

Sources: The Maddison-Project, IMF, December 2017.

4 CHIN A’S ON SH OR E E Q UITY  M A R K E T S

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Where the cash is flowing As the Chinese economy has been growing in complexity,
Aggregate corporate cash flow and investment it has been moving up the value-added chain, experiencing
significant import substitution while grabbing a larger share
34
China fixed asset investment of global auto production. At the same time, companies in
33
China net operating cashflow China are significantly increasing their dividend payments
32
Log scale

31 and expenditures on research and development.

U.S. net operating cashflow
30
29 From investment to consumption and innovation
U.S. fixed asset investment
28
Cumulative change in capex, dividends and R&D spending
1999 2003 2007 2011 2015
US CAPEX US Dividends US R&D
Source: WorldScope, December 2015. 35 China CAPEX China Dividends China R&D
30

$bn
China’s potential increase in free cash flows comes at a 25
time when valuations in the Chinese equity market appear 20
to have converged with the rest of EM (see the Converging 15
valuations chart). This valuation convergence from a 1996 2000 2004 2008 2012 2016
relatively high level in China has been the most important
Source: Worldscope, 2017.
driver of the weak relationship of GDP growth with equity
returns. Distortions in equity valuations persisted in China
The adoption of technology has been an important driver
for a long time mainly because of the relatively small size
of China’s economic transformation. China’s annual R&D
of the market as a share of the economy. China’s high
spending has exceeded that of the EU since 2014 and is
historical valuations were also due to the dominance of
expected to overtake the U.S. position in 2019, according
retail investors, who still make up about 80 percent of the
to the latest OECD figures. Furthermore, the sheer size
market, Bloomberg reports. But both of these factors have
of the Chinese market and the rapid adoption of mobile
been gradually changing. The strong IPO pipeline over the
technologies has pushed online sales in China beyond those
past few years has increased the size of the market, and the
in the U.S. in 2012. Adoption of digital services such as the
agenda to improve the connectivity of the Shanghai stock
WeChat social media platform—which reached the 1 billion
exchange with other financial centers is gradually turning
user mark in early 2018—surpassed the most optimistic
the Chinese equity market into a more institutional one.
projections, opening up new avenues for online commerce
and mobile banking. See the China goes online chart.
Converging valuations
Price to earnings ratios: EM vs. China
China goes online
60 Growth of apps in China
China Shanghai
PE Ratio

40 1,200 200
# Apps with over 10mm active users (RHS)
WeChat users (mm ppl)

1,000
20 150
Number of apps

MSCI EM 800
0
600 100
2003 2006 2009 2012 2015 2018
400
50
Sources: Haver, CEIC and Bloomberg, December 2016. 200

0 0
2015Q4

2016Q1

2016Q2

2016Q3

2016Q4

2017Q1

2017Q2

2017Q3

2017Q4

For these reasons, we believe China’s growth not only will

be above average but that it is likely to be much more stock-
market friendly than it has been in the past. This implies the
Source: CNNIC, 2017.
relationship between GDP growth and equity returns will
become stronger over time. T H E NE X T BI G T HI NG I N E ME R GI NG MA RKET S 5

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Macroeconomic challenges
The profound economic transformation that China is going China’s rising debt problem
through has created imbalances and policy challenges that Private credit as a share of GDP
need to be addressed sooner or later if the country is to
continue on its path to prosperity. The list of potential concerns 250

and things that could go wrong in China is relatively long. Most Spain

Private credit as a share of GDP

of them arise from the somewhat inexplicable desire to have 200
an absolute number for economic growth as a policy objective
Japan U.S.
and the insistence on keeping growth high at almost all costs.
150

In some sense, China has been going against history by Thailand

China
creating an unprecedented prosperity for a huge number of 100
people using an alternative economic and political model.
Although some would argue that China may be getting to a
level of GDP per capita that will test the limits of this model, its 50

track record of economic achievements over the past 30 years
is impressive.
More recently the model is starting to show different
vulnerabilities, particularly with regard to the high levels of
debt. History shows that credit booms such as the one that
China has gone through since 2005 tend to end badly (see the
China’s rising debt problem chart). It is a danger signal that the
increase of leverage in China may be happening at an earlier
stage of development and at a faster pace than other countries
where a similar pattern was observed and invariably ended in
a major financial crisis. But it is also true that China, unlike other
emerging economies, has a significant external surplus and a
relatively closed financial system, making the risk of a financial
crisis of the traditional sort relatively low.
It is unclear to what extent Chinese authorities are
committed to financial reform and a full opening of their
capital account, both of which are indispensable ingredients
for successful financial market development. Reform has
been one of the top priorities of the government and is a
relevant component of their narrative. But the evidence and
the results have been mixed. There has been a tendency,
particularly in 2016, to interfere in regular equity market
dynamics, and the management of FX policy has sometimes
lacked clarity and been poorly communicated.
1980 1985 1990 1995 2000 2005 2010 2015
Source: BlackRock Investment Institute, 2017, using data from the Bank for
International Settlements.
The excessive liquidity that has been required to sustain high
levels of growth has also been creating significant capital
outflow pressures. When so much wealth is created in a
relatively closed economy, local participants try to diversify
their investments in offshore assets. But it now appears that
capital outflow pressures have somewhat abated as the
demand for foreign currency to reduce external liabilities by
the private sector has been trending down.
The bilateral relationship with the U.S. is entering a new
and potentially more difficult phase, with the possibility
of a trade war, investment restrictions and increased
geopolitical tensions. An escalation in tensions with the
U.S. would certainly destroy economic value for both
countries, but China may get the worst of it. China has been
trying to diversify away from the U.S. by rebalancing its
economy toward domestic consumption, and by creating an
alternative multilateral financial system, but it would still be
vulnerable in this scenario.

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Reform agenda and
investment opportunity
Although reforms are hard and cost political capital, Chinese
authorities are well aware that reforming the economy is the
only way to continue with sustained growth. Our custom
indicators that track the intensity of discussion about reform
in the People’s Daily show that terms “supply-side reform”,
“Environmental” and “Financial Deleveraging” started to
become relevant at the end of 2015 and gained momentum
throughout 2016 (see the Focus on reform and investment
charts). A similar count of the number of articles shows that
the Chinese government has also put strong emphasis on
infrastructure investments, for both trade linkage with Asian
and European countries and technology upgrades (e.g. 5G,
cloud), which could be an important driver of future growth.
As China continues to reduce its reliance on external demand
it has also been pursuing an alternative multilateral approach
by sponsoring new initiatives that rely less on the U.S. and
Europe, such as the new Asian Infrastructure Investment Bank
and the One Belt One Road initiative.
A focus on reform and investment
Articles in People’s Daily containing related keywords
400
Belt & road
300
Number of articles
200
Supply side reform
100
Environment Big data/IT
0 0
2014 2015 2016 2017 2018
Source: BlackRock, March 2018, analyzing articles in People’s Daily.
Where the West appears to be drifting away from
globalization and free trade, the recent initiatives to
rebalance the economy away from investment alongside
the new approach to multilateralism will make the Chinese
economy more resilient to growing geopolitical tensions.
Chinese exports have already started declining, going from
37% of GDP in 2006 to 22% in 2017, World Bank figures show.
China also has one of the strongest external financial
positions in all of the emerging markets. Its current account
surplus, low levels of external debt and significant base of
domestic savings (see the A strong external financial position
chart) may make China more resilient than other emerging
economies in an environment where goods, services and
capital are likely to move less freely across borders.
The recent deterioration of the geopolitical environment is
occurring at a time when the Chinese liberalization agenda
has led the International Monetary Fund to include the
Renminbi in the special drawing rights (SDR) basket in 2016.
60
50
Health care reform
Number of articles
40
30
Financial deleveraging
Soe reform
20
10 Housing
reform
2014 2015 2016 2017 2018
T H E NE X T BI G T HI NG I N E ME R GI NG MA RKET S 7
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A strong external financial position
Current account deficit vs gross national savings of selected countries. Bubble size reflects ratio of external debt to GDP.

5.8%
Current account deficit, % of GDP

3.8 CRO MYS

RUS
1.8 POL
HUN China
BRA
-0.2
PER
MX PHL
-2.2 IND
CHI INDO
NGA UKR
ZAR
-4.2 ROM COL
ARG TUR
-6.2

10 15 20 25 30 35 40 45%

Gross national savings, % of GDP

Source: Bloomberg, World Bank, May 2017.

Among other measures, Chinese authorities have sectors like materials, industrials and financials. These new
introduced more flexibility to their currency market by economy sectors make up less than 35% of the Chinese
adopting a currency basket that better resembles their equity market, but represent close to 60% of the S&P 500
import/export activity. Authorities have also accelerated index (see the Growing role for new economy shares chart).
the opening of the Chinese local equity market to more However, their representation has been gradually improving
sophisticated institutional investors, mainly through the since 2007 as the “new economy” companies have gained
Hong Kong and Shenzhen connect initiatives. In fixed share in the IPO market where they already drive more than
income, the central bank has already taken initial steps to 50% of all equity issuance.
facilitate the participation of foreign institutional investors
in local bond markets. Growing role for new economy shares
Sectoral makeup of major equity indexes

Although liberalization has been moving more slowly than 100 Telecom services
originally expected, MSCI has already started the inclusion Health care
New
Cons. staples
process of the local A Share market in the main Emerging economy
Cons. disc.
Market index, broadening the representation of China in 75
Index sector composition

global capital markets and likely drawing additional inflows

Info. tech.
of capital. Along the same lines, China is already in the
process of being incorporated into some of the main fixed 50 Real estate
income indexes. 1 Utilities
Industrials
Materials
In terms of sector representation, the Chinese equity market 25 Energy

is also likely to experience an important transformation in

Financials
favor of new economy sectors that will drive future economic
growth. Many of these are associated with consumption, 0
EM World S&P China A
services and technology and are less associated with more
traditional and over-represented manufacturing-driven Source: MSCI, March 2018.

1 https://www.bloomberg.com/company/announcements/bloomberg-add-china-bloomberg-barclays-global-aggregate-indices/

8 CHIN A’S ON SH OR E E Q UITY  M A R K E T S

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One fact that is often overlooked about the China A-share activity, which is already captured in the main economic
market is how large and idiosyncratic it can be, in the context activity indicators. Most notably manufacturing and services
of other emerging equity markets. The A-share market is PMIs turned positive in 2016 and have been accelerating,
already one of the most liquid in EM (see the Large and making China one of the most important drivers of the recent
liquid chart) and its correlation to the U.S. and other major global reflation trend.
developed markets has been relatively low, at around 0.2. By
Optimistic on China
the time the full integration of A-share market in the MSCI EM
Companies expressing positive view in conference calls
index is finished, China may likely represent more than 40%
of all EM.2 Over time, these attributes will make China more 78%
difficult to cluster with other equity markets for broader index

Positive vs. negative articles

representation and it may actually drive some portfolios to 74
start thinking of China as a standalone market instead of part
of EM. Chinese equities thus have the potential to become a
70
standalone asset class.

Large and liquid 66

Size and trading volume of selected equity markets

140 3,500 62
Billion USD (average daily volume)

120 3,000 Oct 11 Oct 12 Oct 13 Oct 14 Oct 15 Oct 16 Oct 17

Trillion USD (market cap)/

Number of liquid stocks

100 2,500
Source: BlackRock, March 2018 using data from FactSet.
80 2,000
There is much at stake as China faces a global geopolitical
60 1,500
environment that may continue to deteriorate at a crucial
40 1,000
time in the country’s economic history. As China continues
20 500 its long path to prosperity, authorities have recognized that

0 0 preserving economic and financial stability has to be the top

U.S. EM China A Japan priority in order to be able to continue fostering financial
Market cap Average daily volume reform and economic rebalancing that underpins the positive
Number of liquid stocks prospects of Chinese equity markets.

Source: Bloomberg, March 2018. Liquid stocks are those with average daily volume > Despite the economic and demographic challenges that
US$5m.
China is facing, other structural conditions—such as a
The improved prospects for Chinese equity beta are giving large labor force and an ongoing urbanization trend—will
rise to some interesting trends. Global companies that have continue to support medium-term prospects for Chinese
ongoing activities in China often discuss the economic and economic growth. And as China continues to experience
business outlook at their conference calls. After a difficult above-average GDP growth, improvements in the structure
period in 2014-2015 there is now a marked improvement in of its equity markets are likely to foster a closer interaction
market outlooks as more companies are talking positively between the economy and markets, a process we believe will
about China (see the Optimistic on China chart). To some make Chinese equities an attractive investment proposition.
extent these improved outlooks relate to the coordinated
fiscal and monetary policy initiatives that authorities have
implemented and the consequent upturn in economic

2 See MSCI “Are you Ready for China A Shares?” https://www.msci.com/www/blog-posts/are-you-ready-for-china-a/0674848226.

T H E NE X T BI G T HI NG I N E ME R GI NG MA RKET S 9

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10 CHIN A’S ON SHOR E E Q UITY  M A R K E T S

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