China’s entry into the MSCI global indices is a historic milestone. The MSCI inclusion is small, but slightly higher than expected.
China’s efforts in re-regulating stock trading suspension, the expansion of the Stock Connect scheme and the relaxation of new product pre-approval, as well as the support of the international investment community, have worked.
The goal of China’s long march toward global markets is now finally in sight after three years of bidding. As such, initial market reaction should be positive, especially toward larger caps. But challenges remain.
The leading indicator for global trade growth has peaked, hinting at moderating growth ahead. Our other leading indicator models are also pointing to slower growth.
Presumably, as China has a substantial domestic market, and consumption now contributes half of the country’s economic growth, slowing global trade will likely affect other emerging markets more.
Thus, emerging markets’ performance relative to Shanghai will wane in the coming months. But small inclusion limits the contribution of Shanghai to the MSCI EM index return. While the inclusion bodes well for large-cap blue chips, slowing growth suggests allocations toward these stocks, with or without the inclusion.
The scaled-down inclusion means less index weight of 0.7 percent initially, equivalent to incremental fund inflow of about US$10 billion in a market that is about US$8 trillion in size and trades about US$50 billion or more a day.
The Chinese market has depth and does not really need “foreign rescue” as many suggest. The lift on sentiment in the near term will be much more significant than the incremental fund flow initially.
A shares can be inscrutable, with a different trading environment that international fund managers will find it hard to adapt to.
To avoid an inscrutable market, active funds that tend to track MSCI indices can opt not to include A shares in their portfolios, as its small index weight is unlikely to sway performance.
The Chinese market has higher valuation compared with international markets. For instance, Hong Kong, long regarded as a China proxy with more than 70 percent of listed companies’ earnings from the mainland, is still seeing 20 percent discount of its H shares relative to A shares.
The global integration of the Chinese market will likely lower A shares’ valuation to the global level.
It is difficult to gauge whether A shares will adapt to international best practices, or the other way around. Recent experience since the launch of the Stock Connect program seems to suggest that traders from A shares are applying their trading strategies, at times not entirely legitimate, to trading in Hong Kong, triggering violent swings in some stocks.
International fund managers may have to acclimatize to A shares’ trading environment, much like how the Mongol warriors were “tamed” by the ancient Han.
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