The rally in Chinese equities is part of a longer term trend rather than a “one-off windfall”, according to Old Mutual Global Investors’ John Ventre, who says that though China funds have been the best performers so far in 2015, there are a number of reasons why the rally is set to continue. 
There is no doubt that 2015 has been a particularly good year for equities and this is shown as every equity sector in Investment Association universe is up at least 6.6 per cent year to date, according to FE Analytics.
However, this year’s surprise package has come in the form of Chinese equities, as due to the recent Shanghai-Hong Kong Stock Connect programme and the expectation of looser monetary policy from the country’s central bank, the IA China/Greater China sector has been the best performing peer group with returns of more than 25 per cent.
Performance of sector versus index in 2015
Source: FE Analytics
On a fund-by-fund basis, interspersed with those focused on rebounding Russian equities, 18 out of the top 25 top performing IA portfolios this year – or 72 per cent – come from the IA China/Greater China sector.
While the top performing fund in the sector – GAM Star China Equity – is up 37.75 per cent this year, Aberdeen Global Chinese Equities, which sits at the bottom of the sector table, is still up 17.4 per cent.
Clearly, eyebrows are always raised when an equity market performs so strongly in such a short period of time – especially as the key drivers have largely been due to weaker-than-expected economic data.
However, Ventre – head of multi-asset at the group – is still very bullish on China funds.
“We think this is the beginning of a longer term trend, not a one-off windfall,” the manager (pictured) said.
Ventre, who has been positive on the asset class for a number of years now, says there are a number of reasons for recent bull run. Firstly, he says it is a continuation from the fourth-quarter rally last year – when Chinese funds surged on the back of bargain valuations.
Performance of sector versus index in 2014
Source: FE Analytics
The second driver, according to Ventre, is because of the dovish tone from China’s central bankers.
“The Chinese central bank has already cut interest rates and has made the second of two reserve ratio requirement cuts this week. Both that looser policy, and the expectation of looser policy, has got a very strong equity rally underway,” he said.
“It is important to understand that, locally, Chinese investors are massively under-invested in their own equity market. Essentially what happened was that they had a bubble in 2006/07; it popped and bang went a nation’s equity culture so they all put their money in property. It’s important that China’s wealth begins to rebalance out of property and into equities.”
“Obviously, [the rally] started from very cheap valuations and it’s quite a powerful dynamic when equities start cheap and you’ve got a central bank which is very much on your side.”
Ventre says there are more technical dynamics at work though, which revolve around the recent Shanghai-Hong Kong Stock Connect.
He says that it has been the ‘A Shares’, or mainlaind Shanghai, market which has so far driven the rally but he expects China funds to continue to benefit as more and more domestic investors move their money into the ‘H Shares’, or Hong Kong, market.
“The early move has been within the A market, which us overseas investors don’t really benefit from. What we haven’t yet seen, or haven’t seen since the start of this month, was much flow from out of China and into the offshore listing.”
“This change has been due to a change in regulation which allows Chinese mutual funds to use Connect for the first time. We should expect to continue to see onshore Chinese investors bottom-fishing in the cheaper Hong Kong market, because you can basically buy exactly the same company in an H-listing rather than an A-listing on a 30 per cent discount.”
“If I owned the A-listing, I would be a bit less bullish at this point as that valuation has started to move into that more normal territory. However, there is still a lot to go the H-market and we would expect to see is that happen as the mainland China bull rally continues.”
The major reason why he says that will continue is because policy makers will not want to de-rail a bull market just as an equity investing culture is returning and, as part of the restricting of the Chinese economy, they want businesses to be less reliant on bank lending and more on investor funding.
Russ Koesterich, BlackRock’s global chief investment strategist, sees why the rally can continue but urges investors to be very selective as he has noticed disturbing developments in the region.
“We are seeing some worrisome signs of increasing speculation on the part of investors,” Koesterich said.
“For example, following a rule change allowing for multiple accounts, mainland stock investors opened 3.25 million new accounts, a record. In addition, margin debt – in other words, borrowing to buy stocks – has risen sharply in recent weeks.”
“We favor shifting our China exposure to the H-Share market, which is traded in Hong Kong. We are not seeing the same excesses in this part of the market and valuations are much more reasonable. H-Shares are trading at less than half the current valuation of the A-Share market.”
Of course, many investors may simply view the rally in China as a mere rebound and have played it as a short-term trade, similar to what some have done with Russia funds over recent months.
However Ventre, who has comfortably outperformed his peers over the last five years as manager of the Old Mutual Spectrum, Voyager, Generation Target and Foundation fund of funds ranges, is confident these are the early stages of a prolonged bull-market in Chinese equities.
Performance of manager versus peer group composite over 5yrs
Source: FE Analytics
He says the state of the Chinese economy is now very similar to that of Japan between the mid-1970s and 1980s when the country’s stock market delivered significant outperformance relative to global indices.
“If you line up the two economies historically, China is more or less at the point when Japanese equity returns inflected quite positively higher,” Ventre said. “[Japanese equites] were poor for about 25 years because they were building a lot of infrastructure. Ring any bells?”
“China has been doing the same but is now slowing down that fixed asset investment and looking to rebalance its economy to better quality, more consumption-led growth. As we saw that change in Japan, there was significant equity market appreciation.”
“The lesson here is that as the economy slows, the stock market doesn’t necessarily follow. Shareholders like companies which are throwing off nice free cash flows rather than building lots of assets.”
He added: “As this inflection occurs in China, like it did in Japan, you are going to get equity appreciation.”