A decade ago, China launched an industrial strategy to upgrade to a high-tech industrial base called ‘Made in China 2025.’ Little did they know it would be finalised in a year when their main economic rival would attempt to definitively pivot towards protectionism.
It could be that the authorities anticipated the struggles they would experience in shifting economic growth from a reliance on the property sector and the uncomfortable comparisons that would bring with Japan’s lost decades.
For equity investors, the reforms to the property sector have had a profound impact, compounded by the first trade war and a crackdown on the freedom of technology companies.
The main Chinese equity indices are lower over the past five years to the end of May. Onshore/offshore, A, B and H share indices have at times lost more than 40% of their value in sterling terms, and some over 55%.
Amid so much negative sentiment in early 2024, index valuations, as measured by the forward P/E, dropped to 20-30% of their post-global financial crisis (GFC) averages¹.
In the second half of the year, government initiatives unleashed an almighty rebound, with some indices rising over 30% in a matter of days. Expectations of earnings upgrades compounded upon the low starting valuation. The rally cooled as the year end approached, however 2025 has seen a similarly dramatic performance, albeit this time with differentiation.
January’s release of the DeepSeek R1 AI model was a defining moment, challenging the prevailing wisdom that US companies would dominate in AI. This set in motion another ferocious rise in large cap H shares.
In times of divergence in markets, strategic asset allocation decisions, such as benchmark selection, can show up in unexpected ways for those unaware of the nuances.
Any equity region has several indices available. At its most obvious, this can be the intended coverage of the index in terms of region, think pan-European versus Europe ex-UK. However, the difference often lies within the index provider methodology, where free-float adjustment, inclusion criteria and country classification can have an impact on the profile of the index.
China and the wider region have important and often ignored issues here. The broadest definition of China (Greater China) includes Hong Kong and Taiwan. Over the past three years it has paid to invest in the MSCI Greater China index, or strategies that manage around it, because it has a large allocation to TSMC and hence rode the dominant tech/AI theme in wider markets.
If on the other hand you specifically targeted A shares, you missed out on this trend and the 2025 H share rally too.
The MSCI Greater China index meanwhile has had the H share gains this year eroded by exposure to the wider tech sector, namely TSMC and its close association with the US AI champions.
That is where slightly broader China indices come in handy, such as MSCI China. This index does not include Hong Kong and Taiwan, but does target an A share component, alongside H shares, P chips and Red chips. A shares are capped by index inclusion criteria and inclusion ratios.
Failing to assess the underlying positions of a passive or active holding with respect to these differences may have seen a few investors surprised with how their portfolios have performed this year.
Turning to where we stand today, there has been a re-rating, meaning valuations across China equity indices sit much closer to the post-GFC averages. In other words, the easy money has been made, especially when you consider the relative performance to US equities.
China is still on the cheap end of the spectrum when looking across other regions. The shift in narrative around AI and the benefits of Made in China 2025, which now means manufacturing in China is not all about cost, could be felt for some time.
Of course, other factors explain some of the valuation discount. The elephant in the room is Taiwan. Most are aware of the invasion risk, but it is unpredictable.
There are different approaches to these types of risk. Perma-bears can be very well appraised of the minutiae of risks but can frustratingly miss out on opportunities whilst holding the intellectual high ground. Others, meanwhile, may continue investing without fully appreciating their exposure, until it matters.
We prefer a more nuanced approach: recognising both the opportunities in China and the risks that may require careful management. That’s why in 2025 we moved our asset allocation to an Emerging Markets ex-China model, with dedicated allocations to China that allow quick and efficient changes to exposure should we need it.
For many this was a pressing issue when China accounted for over 40% of the MSCI Emerging Market index back in 2020, but it remains an obvious risk management improvement that allocators can make to their processes.
¹Between 01/01/2010 and 31/12/2023.
James Flintoft is head of investment solutions at AJ Bell. The views expressed above should not be taken as investment advice.