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From Silk Roads to Stock Markets

Perspectives on Stock Investing

Perhaps not since the Tang Dynasty (618 - 907) has the world at large been so interested in or connected to China. Then, there was the Silk Road, which connected East to West through an unprecedented trade route. Now, a decade after China’s accession to the World Trade Organisation, a similar global thread of commerce binds China to most parts of the world. Initially, Chinese export resurgence was based on labour cost advantages. Now, China is increasingly delving into more sophisticated manufacturing techniques and developing global brands. China also has a seemingly unending appetite for basic minerals, materials and certain food products, which makes it a great destination for producers of such items.

As the Chinese economy’s government controls are gradually liberalised through a more open economic architecture, the impact of policy influences on the Chinese economy and stock markets should wane in coming years. This will help bring tremendous focus to company-specific factors, something that can drastically increase the potential for investment opportunities.

China is a compelling case for financial investors as well. As was the case during the Tang Dynasty, strategy is required. Aspects like infrastructure, market access mechanisms and investment capital are all in place. To that effect, the equity markets of Hong Kong and mainland China represent a tantalising, and perhaps unavoidable, opportunity for investors. Additionally, China’s vast economic connections with the rest of the world make access to Chinese equities possible, indirectly through diversified emerging markets and broader global equity strategies. It is important to understand these strategies and how they fit into the wider context of China’s economic growth.

Direct China Exposure

The equities markets in China have grown immensely as the country has listed its massive state-owned enterprises. A list of the top 10 companies in the world by market capitalisation will show that China now regularly grabs three or four of the top spots, a far cry from the top-10 composition just a decade ago. Shanghai, the more popular of the two mainland exchanges, tends to be heavy in large-cap names with some of the biggest banking, energy and industrial companies by market capitalisation. The Shenzhen Stock Exchange is smaller, but more diversified, with more companies that cater to Chinese consumption and an industrial investment theme - companies in the consumer discretionary, industrial machinery and information technology sectors. Since investment access to Shanghai/Shenzhen requires Qualified Foreign Institutional Investors (QFII) quotas, the Hong Kong equity market, unencumbered by such QFII quota needs, presents itself as a great alternative. With one of the most advanced stock exchanges in the world and a tax regime that is very supportive of cross-border portfolio investments, Hong Kong has been the conventional market through which investors have accessed China.

Hong Kong’s status as the gateway to China is greatly bolstered by an ever-increasing roster of mainland companies that are keen to list on its exchange and attract the vast sums of global capital awaiting Chinese investment opportunities - from large state-owned giants to small, privately owned, niche companies engaged in the critical sectors of China’s industrialisation. Today, more than 50% of the market capitalisation of equities listed in Hong Kong represent Mainland companies or other companies doing substantial business in the Mainland. This gives investors a substantial investment range through Hong Kong. Historically, the rivers of global capital listings invariably flowed into New York or London, but in recent years, there has been a prominent new tributary to Hong Kong. Recent efforts by regulators to set up an offshore yuan market in Hong Kong will increase that flow.

Indirect China Exposure

Investors can also gain access to China through a diversified emerging market strategy or a broader global equity strategy. Investing this way can combine the benefits of China’s economic growth with global diversification. There are really two stories with the indirect China strategies; one is an attempt to access the growth of the domestic consumption markets and the other is an effort to tap into the Chinese engine of growth that services the external global markets.

Diversified Emerging Markets

The connections between China and the world’s emerging markets are growing exponentially. China is beset with an imbalance between the size of its population and its resource base. An emerging markets strategy is centred largely on the emerging world’s ability to feed China’s tremendous appetite for commodities such as oil, coal, iron ore, copper, soybeans and meat.

Brazil is a good market to gain indirect exposure to China because they export so much of their iron ore and soybeans to China. A water shortage in the northern areas of China that traditionally produced soybeans has resulted in decreasing domestic supply and China now sits as the world’s largest importer of soybeans. Brazil is ready to meet that need. Similarly, China is the largest importer of iron ore and buys over 20 million tons of it from Brazil every month. It is, therefore, no surprise that many treat Brazil as an option on Chinese industrial growth.

China has also become the world’s leading importer of crude oil on an incremental basis. The three state-owned oil companies are seeking more and more overseas oil development projects; this holds positive consequences for oil-rich markets in Latin America and the Middle East.

Over the last decade, markets supplying goods to the American economy were the biggest beneficiaries of the U.S. consumption boom. In much the same way, as China consumes more, it is bound to be very positive for global companies that cater to its consumption needs. As China remodels itself into a consumption-driven economy, the biggest beneficiaries of that change will be the low-cost emerging market countries that can provide these consumption goods. Asian emerging markets stand in a particularly good position to benefit from this trend. Trade between China and the rest of Asia has grown significantly over the past several years. For example, Taiwan signed a landmark trade deal with Beijing in August of 2010. Similarly, South Korea, who already sends 25% of its exports to China, has recently announced they will be holding trade talks with China some time in 2011.

Broader Global Equity Strategy

A diversified emerging market strategy brings increased diversification over direct investment, but this diversification could be enhanced further through a strategy of capturing exposure to China through a broader global equity mandate. Rather than relying heavily on imports to China, a global equity strategy can be more balanced, playing between imports and China’s exports to the developed markets. China’s imports hold increasing sway over the economies of developed markets. In the second quarter of 2010, Germany’s outstanding GDP growth of 9%, annualised, was due in great part to massive imports of cars and machinery items from China. Looking at the S&P 500 Index, approximately 35% of the revenues of listed companies are believed to come from non-U.S. sources, and a significantly growing part of that is China. Some of these features of the Chinese growth juggernaut can be captured very well through a broader global strategy.

Risks to a China Strategy

Regardless of the particular strategy, there are some risks to any China-centric equity strategy. China has seen and will probably continue to see a great deal of “hot” money flowing into the country. The result could be a preponderance of asset bubbles, already seen somewhat in Chinese property markets.

There is also a demographic risk in China, which is perhaps 15 years remote. With population controls still in place, China could lose its demographic advantage as its relatively young population ages. Such a shift also has the possibility of altering the consumption and investment patterns in China, moving to more defensive items as there has become proportionally fewer young people to support the ageing population.

This article merely scratches the surface of the possibilities in gaining equity exposure to China. For those looking for further assistance, Principal Global Investors stands ready to help. We have extensive capabilities in Hong Kong and China equities, global and Asian emerging markets, and a host of broad global equity strategies. Our core, bottom-up investment process focuses on the early identification of fundamental change and we pride ourselves on our purposeful integration of thorough fundamental research with sophisticated quantitative ranking tools.

Disclosures
This document is issued in Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and in Hong Kong by Principal Global Investors (Hong Kong) Limited which is regulated by the Securities and Futures Commission. In Singapore this document is directed exclusively at institutional investors [as defined by the Securities and Futures Act (Chapter 289)].