Is China's Stock Market About To Go Ganbusters? – Forbes

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Waiting on the MSCI. The index company will decide whether or not to include mainland China’s corporate A-shares in the MSCI Emerging Markets Index on June 20. (Photo by VCG/VCG via Getty Images)

As the world is glued to the James Comey hearing on Donald Trump and the Russians, China is quietly on its way to becoming an even bigger equity market. If the MSCI index includes Shanghai and Shenzhen listed stocks, known as the A-shares, in its massive MSCI Emerging Markets Index on June 20, it opens up a whole new foreign market for China. While the U.S. wallows in political scandal, China is getting bigger, and better.

There is no guarantee that MSCI is going to pull the trigger on the A-shares, but if so it would mean that funds like BlackRock’s iShares MSCI Emerging Markets (EEM) exchange traded fund would have to rebalance and allocate some of its China securities, nearly all of them on the Hong Kong stock exchange, and buy those listed on mainland exchanges. Mutual funds that are benchmarked to the MSCI Emerging Markets Index will also be required to hold some A-shares.

Two years ago, the Chinese were betting on the MSCI giving the A-shares the greenlight. The Shanghai and Shenzhen indexes rose over 40% in six months. When MSCI rejected the A-shares on a number of regulatory and compliance issues, the stock markets tanked. The Deutsche X-Trackers China A-Shares (ASHR) ETF is down 50.4% since its peak in June 2015 as a result.

MSCI indexes is one of the most followed indexes in the fund world. They have $10 trillion in benchmarked assets with $1.6 trillion of funds tracking the MSCI Emerging Markets Index alone.

Adding the A-shares to its roster of stocks would trigger significant inflows into China’s mainland equity markets as required by fund mandates. If a mutual fund or ETF tracks that index, it has to have some of its assets weighted to what the index holds. If the index holds 20% Brazil, a fund can be over or underweight, but will still hold Brazil. If MSCI adds 1% A-Shares to the mix, that’s a lot of money suddenly mandated to China. One percent of the $32 billion iShares MSCI Emerging Markets ETF alone is $320 million.

See: MSCI China A-Share Inclusion Decision 2017 — KraneShares Webinar

“I would not wait or rest my hopes on an inclusion,” says Andy Rothman, chief strategist for the China specialists over at Matthews Asia in San Francisco. “It’s going to happen. I just don’t know when.”

Once the A-shares are included, it opens up an entire market for investment bank research into the stocks listed in the index. This is a global investment banker’s dream, especially the big boys with Asian branches.

The Shanghai Stock Exchange is the fourth largest in the world.

Moreover, an inclusion, whether it happens in two weeks or two years from now, is a step in the direction of a further opening of Chinese capital markets. China is investment grade. It’s bond market is the third largest in the world, despite being relatively closed to foreigners.

Signage for the Shenzhen-Hong Kong Stock Connect is displayed during the launch ceremony at the Hong Kong Stock Exchange in Hong Kong, China on Monday, Dec. 5, 2016. Hong Kong Exchanges & Clearing Ltd. (HKEx) today unveiled a link with Shenzhen two years after the start of the first with Shanghai. (Photographer: David Paul Morris/Bloomberg)

Getting The A-Shares Ready For MSCI EM

Back in March, MSCI released their consultation on A-Shares from their client base. It is not their own opinion, it is the opinion of fund managers and other securities professionals on how to best include the mainland equities into the major indices.

“The tone and tenor of this year’s consultation is a step up from market regulations from the past,” says Brendan Ahern, CIO of KraneShares, a China specialty ETF firm in New York. This year’s consultation introduced a smaller number of A-shares ready for the big time, down to 0.5%. The lower number of companies makes it “more digestible” and maybe even more likely that the A-shares get the go-ahead in June.

Some of the concerns are over settlement days within the Stock Connect programs, and eliminating counter-party risk between trades going from Hong Kong to Shanghai or Shenzhen. The new connect framework may ultimately prove to be the icing on the cake for MSCI, making it easier than the older qualified foreign institutional investor program, or QFII.

The new consultation is still in the proposal phase. Some of the proposals are:

Proposed change  Factors to consider
Include only large cap stocks available on the stock connect programs in Shanghai/Shenzhen 97% of the MSCI China A International Index is available via connect programs, including mid-caps*.
 Eliminate dual listings Dual share classes are not an issue in other MSCI Indexes, but if MSCI EM holds China A an H shares on the Hong Kong Exchange, it is best to only include the A-shares that are not listed in Hong Kong.
 Remove securities suspended for more than 50 days At the time the consultation was written, 32 companies were suspended.

*Data from Bloomberg as of March 31, 2016. Chart by KraneShares.

Once included, China A-shares could take another year or two before they are fully part of the MSCI EM.

“The China A-shares market has a 5% higher earnings expectations than the U.S. equity market,” says Dr. Xiaolin Chen, head of investment solutions at KraneShares. “This is an ideal source of opportunities with lower valuation and higher EPS growth.”

Chen analyzed investment risk by adding 20% A-shares to an emerging market portfolio. The fund without mainland Chinese equities outperformed by around 85 basis points, and volatility fell by 72 basis points, which appears counter to what most investor would think about mainland stocks. Chinese investors tend to treat their local exchanges like a casino, with wild swings in either direction more normal in China than in Hong Kong.

“Regardless of MSCI’s decision, Chinese equity markets will continue to grow,” says Ahern. KraneShares’ MSCI China A-Shares (KBA) fund has been around since 2014.  “We think there’s been significant improvements to market access and regulations that will allow for an inclusion,” he says. A few months ago, he put the odds of an inclusion at 75%. What does he think today? According to people at KraneShares, 70%-75% is still their odds.

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