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China dominates offshore investment themes circa 2022

17 January 2022 Gareth Stokes

The half-dozen or so investment outlook presentations that I attended in the last month of 2021 could be summarised in just two words: China and inflation. Although the likes of Alexander Forbes, Efficient Group, Ninety One, Old Mutual, Sanlam and Schroders all discussed a range of investment themes, they all felt it necessary to devote a few minutes to the impact of China’s policy intervention on global markets, and a few more on whether or not US inflation would prove temporary or permanent.

The A-shares, N-shares conundrum

Alexander Forbes Investments started their global investment themes presentation with a more traditional assessment of China’s investment case. They pointed out that the country remained underrepresented on global indices despite its GDP almost rivalling that of the United States. “China is still significantly underrepresented in global indices and China onshore shares, or A-shares, make up only 5% of the MSCI Emerging Market Index,” said Nimisha Bhagwan, Head: Investment Advisory at the asset manager. If all of the A-shares are included, then China’s weighting on this index would be closer to 20%. 

There is no better financial market than China to illustrate the complexity of achieving appropriate offshore exposure in an equity portfolio. The country operates a dual onshore or A-shares market, alongside its offshore  or N-shares market. A-shares are mainland China-based companies traded on the Shanghai or Shenzhen Stock Exchanges. N-shares are issued over companies operating out of mainland China that have listed on the New York Stock Exchange or Nasdaq. 

Global investors are typically playing in the N-share space, thus restricting their exposure to a narrow slice of the Chinese economy. Bhagwan explained that this segment was dominated by communications, consumer discretionary and financial businesses whereas the onshore market was more diversified. It is, of course, worth reminding readers that ownership of China inshore shares is tightly regulated, with foreign investors participating through a Qualified Foreign Institutional Investor programme or similar. 

Three reasons to invest in onshore China

Alexander Forbes’ international asset management partner, Mercer, offers three motivations for investors to include onshore Chinese exposure in their fund portfolios. The first, is that investors benefit from the higher earnings growth and rising valuations from companies with direct exposure to that country’s high GDP growth. The second is that listings on China’s onshore market offer more inefficiencies than those on its offshore markets, allowing active managers to achieve greater alpha in their portfolios. And finally, there is an extremely low correlation between China onshore and other global equity markets. 

There is also a high likelihood of a demand underpin for China onshore shares as global indices adjust to reflect the economic reality. “The under representation of China onshore shares in global indices will result in developed market investors increasing their direct allocations to that market, by either topping up their existing emerging market allocations with onshore China shares, or by managers adopting ‘onshore China only’ strategies,” said Bhagwan. 

South African investors will have to assess their global investment strategies based on their current SA-based exposures. What few local investors realise is that the constituents of the JSE All Share Index generate more than half of their earnings offshore, with 18% of this total coming from China. This exposure to China is courtesy Naspers and Prosus, which in turn have a huge investment in Tencent; but the likes of Richemont and various resource counters also benefit from rising consumer demand out of that country. 

Bhagwan explained: “There are still pros for South African investors who wish to have a separate allocation to China, and these include capturing some of the Chinese growth that is not indirectly driving the earnings of our listed markets, as well as the low correlation to the rest of the global equity universe”. The cons, which we will not dwell on in this piece, include high environmental, social and governance (ESG) risks; the uncertain regulatory environment; and the correlation between emerging market currencies. When all is said and done, the level of China market exposure remains investor specific.

 

So, what about inflation then?

Janina Slawski, Head: Investment Consulting at Alexander Forbes Investments singled out four additional talking points for 2022; but our focus is on the asset manager’s view on global inflation. “There are two views on [US] inflation at this stage, with one camp suggesting it is permanent, and the other transitory,” she said. Neither camp denies that inflation is on the rise on the back of Covid-related supply chain constraints, rising energy prices and volatile house prices. Those in the permanent inflation camp are worried about what happens when, rather than if, central banks begin hiking interest rates. 

Inflation, and one’s view on inflation, is influential in asset allocation decisions. “Investors globally have sought investment opportunities outside of developed markets, which are offering very low yields,” said Gyongyi King, Chief Investment Officer at Alexander Forbes Investments. “They have been investing in growth-focused fixed income asset classes which have outperformed defensives”. But this carry trade theme will come unglued if inflation becomes permanent, forcing central banks to respond. 

King said that global interest rates were likely to creep up during 2022 and 2023 as central banks rein in the loose monetary policy that has existed since 2008 and accelerated through pandemic. “The interest rate cycle is definitely turning, and that means that there will be a rerating of many asset classes,” said King. Asset managers will thus have to reconsider their valuation methodologies and find more value to compensate for the extra cost of capital that results. 

Does gold still have a role to play as an inflation hedge? And could we see renewed interest in crypto assets in a rising interest rate scenario? The outlook for gold and commodities over the next decade seems subdued; but there is plenty of enthusiasm for cryptos, especially among retail investors. The question everyone is asking: At what point do crypto assets become significant as part of an asset allocation? 

As we enter 2022, both Alexander Forbes Investments and Mercer feel that crypto assets “were not yet investible”; but these concerns do not detract from the massive implications that blockchain and its associated technologies will have on financial markets over the long term. 

Passive and sustainable themes dominate

As investors go in search of value, the well-established trend of fund flows to passive investments will continue. Another theme that is gathering momentum is that both active and passive investors are in search of sustainable investment outlets. “We used to refer to this as socially responsible investing and would achieve such outcomes through portfolio exclusions,” said Slawski. “Nowadays we can choose from a world of investment strategies ranging from ESG integration, through to screening in various forms, and thematic impact investing”. 

Sustainable investing will become a major trend over the next decade as investors demand greater engagement between asset managers and the firms that asset managers invest in. Allocators of capital, meanwhile, are more intent than ever on achieving true impact through their financing activities. “South Africa [could benefit from this trend] as international investors look to fund green projects that can assist with the country’s just transition from fossil fuels,” concluded Slawski. 

Writer’s thoughts:
New Year price action on the Nasdaq suggests that US investors are not overly concerned about inflation. On 3 January 2022, Apple became the first company to top US$3 trillion in market cap, while shares in EV manufacturer Tesla jumped 13.5% on the day. What are your thoughts on the likely impact of higher inflation on local and offshore equities through 2022? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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