Ohm Srinivasan, CFA
September 26, 2018
Emerging markets have become volatile in recent months due to the conflict over global trade, especially as it becomes a showdown between the U.S. and China. Both rhetoric and action on this front have been and may continue to be highly unpredictable. The trade war could also have a ripple effect on global growth. At the same time, waiting for all of these macro issues to resolve themselves would most likely be self-defeating. Markets tend to anticipate trend changes before they become front page news. In looking at emerging markets, recent volatility is providing attractive opportunities. We recommend focusing on long-term investments at attractive prices that can weather and/or even benefit from market volatility. As such, we take a closer look at what China has to offer.
China is the second largest economy in the world with $14.1 trillion in gross domestic product (GDP,) falling just behind the U.S. economy which has $20.4 trillion in GDP.1 In less than 10 years, the Chinese economy rose from smaller than Japan to nearly three times its size. It is likely to surpass the aggregate GDP of the 19 countries in the eurozone and could surpass that of the U.S in just 10 years.
China’s 1.4 billion citizens represent almost 20% of the world’s population. However, the U.S. continues to be a substantially wealthier nation, with GDP per capita six times larger than that of China.2 As a result, China continues to be labeled an “emerging country,” but is well on its way to developed status.
The country has been a substantial driver of global growth. Over the last three decades, China has contributed more to global growth than the U.S., at 22% and 20% respectively, which is a substantial shift from the decades prior.
China currently contributes approximately 35% to global growth,3 more than twice the U.S. contribution; and as standards of living continue to improve, future growth potential remains large.
Some of the world’s largest capital markets are located in China. The stock market capitalization of listed domestic companies in China and Hong Kong is over $10 trillion, with high trading volume and liquidity. Beyond the stock market, China’s fixed income, convertible bonds, real estate, private equity and venture capital markets are also substantial. As a sizeable developing economy, China is the principal consumer of raw materials which tend to drive global commodity prices.4 Irrespective of direct investments, China is too big to ignore as it impacts economies and financial markets globally.
Access, Policy and Risk
Relative to the size of the economy and financial markets, foreign investment in China is limited. The Communist-run government has enacted strict capital controls to help manage (or some would say manipulate) their currency, the Renminbi. Chinese citizens are limited in terms of how much they can invest internationally, while foreigners have limited access to Chinese financial markets. This has been one the biggest barriers to investing in China.
However, in accordance with its five-year plan, China has opened up financial markets by providing new avenues for investments. They have also been recognized by the International Monetary Fund as one of the five reserve currencies for the Special Drawing Rights basket. While this is a welcome change, the transition could potentially unlock risks as China tries to relax polices in its traditionally controlled economy.
Although capital markets are not easily accessible, the prospect of tapping into China’s status as the primary driver of global growth makes it worthy of investment consideration. While a discerning and cautious approach is warranted, there are several ways for sophisticated investors to invest in China. Understanding government economic and regulatory policy is an important component for successful investing. For instance, Chinese government initiatives to boost innovation has helped support technology companies who are now global leaders.
Investment opportunities have become more attractive as noise from trade wars has repriced many assets. Generally, an investment in emerging markets is likely to have a very heavy dose of exposure to China as it already makes up 31% of the MSCI Emerging Market (MSCI EM) Index. It is the view of the CIBC PWM Asset Allocation Committee that an Asia focused approach to emerging markets is most timely, so that further heightens the allocation to China. More broadly, most other emerging economies are heavily dependent on the Chinese economy due to trade linkages.
Active management and security selection are critical when investing in China. Passive index funds or ETFs are dominated by the state sponsored banks, which we view as the least attractive part of the Chinese equity market. Due to limited institutional competition, the Chinese market remains inefficient, creating more opportunity for research-driven active managers to outperform. Furthermore, owning the right assets is more important than short-term outperformance in emerging markets, especially in times of stress. Finally, stock market valuations are approaching historically inexpensive levels, especially relative to other parts of the world.
Unique Opportunity: Chinese Convertible Bonds
As Chinese capital markets develop, there are an increasing number of potentially viable opportunities for investors willing to entertain non-traditional strategies. One example is the convertible bond market. Convertible bonds are essentially a combination of a bond and a stock call option, which gives you the right to buy the stock at a set price. These bonds have the protection of the bond floor and many structural advantages, such as reset/put provisions. The reset provision allows the issuing company to grant a greater amount of shares to the convertible bondholders to offset any decline in the stock price. Essentially, the lower the stock price goes, there is potential to get more stock call options to maintain the total value of the convertible bond. This feature materially limits the potential downside market sensitivity. This has historically resulted in the vast majority of Chinese convertible bonds to have a terminal value above $100 with an average price of $140.5
While the downside is limited, these convertible bonds can capture 40-50% of the stock market upside. This opportunity comes at a time when stock valuations in China are historically cheap, convertible bond issuance is growing and upside potential can materialize when noise from the trade wars dissipates.
Despite all of the headlines surrounding China trade wars with the U.S. and heightened volatility, long-term opportunities have become more attractive. Whether through equity markets or less traditional paths, investors can participate in the opportunities provided by this rapidly developing economic and financial titan. As believers in a global perspective, the CIBC Asset Allocation Committee and investment team will continue to evaluate and vet growth opportunities in China, and where appropriate, make high-quality strategies available on our investment platform.
Ohm Srinivasan is an investment portfolio manager and co-heads the hedge fund research efforts within the Multi-Manager Investment Program (MMIP) based in Boston. With more than 17 years of industry experience, he is responsible for managing the MMIP hedge fund platform.
CIBC Private Wealth Management’s Asset Allocation Committee recommendations express our views on directional portfolio shifts driven by an assessment of relative risk and reward and do not take into consideration individual suitability requirements. At CIBC Private Wealth Management, asset allocation may be customized for each client, so a client’s particular portfolio allocation may not follow these recommendations. Some recommendations referenced may not be appropriate for your specific situation, so you should consult with your financial advisor regarding your unique circumstances.
1IMF World Economic Outlook April 2018.
4Business Insider, China’s dominance of global commodity markets, in one chart, 08.08.2018.
Dave Donabedian, CFA
March 26, 2014
Dave Donabedian, CFA
August 25, 2015
Matt Scherer, CFA
March 29, 2018
* Required fields
Internal Custody:If your assets are custodied with Atlantic Trust, please select the internal custody version of Atlantic Trust Portfolio Online to view your portfolio information.
External Custody:If your assets are custodied with an external custodian, such as Schwab, Fidelity or The Bank of New York, you may access the external version of Atlantic Trust Portfolio Online.
Sponsored Funds Investors:If you are an investor in any of the Atlantic Trust Sponsored Funds, you may access the Atlantic Trust Investor Dashboard here.
Safari Browser Users:To access login links, you will need to deselect the "Block pop-up windows" option under your security preferences.
For further assistance, please contact your Atlantic Trust client service team.