Most global investors have very small allocations to China that do not appropriately reflect the size and importance of the Chinese economy or its assets. We expect that will change significantly over the next few years, and Bloomberg’s inclusion of the Chinese bond market at a bit over 5% weight is the first material shift by one of the major indices to boost exposure to Chinese onshore financial assets. Many more moves like this are coming and will reshape global portfolios, and we would encourage investors to think proactively about the exposure they want to China now.
The availability of Chinese assets provides a meaningful opportunity for diversification. Chinese assets have a fairly low correlation to global assets because the Chinese economy is largely driven by domestic demand, which in turn has its own idiosyncratic drivers. The motivations for China to open up their markets are equally clear. China wants foreign capital to deepen their capital markets, help further develop their economy, and bring in flows that will allow them, over time, to relax capital controls and create a two-way currency market. The launch Monday of an RMB-denominated oil future open to international investors is another step in the same direction. The oil exchange reflects a desire to harness financial markets to more efficiently allocate capital, and doing so will improve global commodity liquidity. While the bond inclusion is the bigger deal, both of these developments highlight the fact that going forward Chinese assets will play a significant role in most investor portfolios. While today foreigners have a tiny share of their portfolios invested in Chinese assets, particularly relative to the size of the Chinese financial markets and economy, we expect this to change dramatically in coming years.
Chinese Bonds to Enter the Index Next Year and Be Phased In to Full Weight
Beginning in April 2019, China will be included in the Bloomberg Global Aggregate. By 2021, Chinese bonds will make up about 5.5% of the aggregate. This is a big deal for global capital allocation, as trillions of dollars track this index explicitly and trillions more use it as an important reference for their allocation. Given that investors already hold some government bonds, this means hundreds of billions of dollars will likely move into the bond market. In a statement, Bloomberg said Chinese bonds now meet inclusion criteria that the bonds be investment grade, freely tradable, allowed to be currency hedged, and “free of capital controls.” If other flagship indices follow suit, we estimate that very roughly something like $1.2 trillion will flow into the bond market, as we show in the red bar below.
If China Continues on Its Current Path, Chinese Assets Are Likely to Represent Roughly One-Third of Investor Portfolios
An even bigger flow will occur as Chinese stocks also gain inclusion to equity indices. To illustrate the point, if Chinese bonds and stocks are given a market weight in global indices, we will move from the chart on the left to the chart on the right. As of June, onshore Chinese stocks will join the major MSCI indices (the offshore Hshares are already in the index). Though the inclusion weight will initially be very low, we expect onshore equities to eventually be included at their full weight (about 17% of global market cap). This would represent a staggering shift in the source of global returns.
Opening China’s Markets Makes Sense for China…
Chinese policy makers have been working assiduously toward opening their markets for years. The stock and bond connects, working with outside investors to deal with issues like currency hedging and intervention, fit into a chain of reform that stretches back to 1978, an evolution we have described elsewhere. The key thing for foreigners to recognize is that opening their markets serves China’s interests. To continue to reform and reach their own growth targets (becoming a “moderately prosperous society”), China needs to deepen their capital markets and transform them into a source of capital for increasingly private-sector-driven savings (i.e., insurance and pension funds) and investment by households and innovative private sector businesses.
…and for Foreign Investors
China represents an almost unprecedented opportunity for investors to diversify their portfolios. While China has a large influence on other major economies and vice versa, growth is primarily driven by the domestic economy and domestic drivers. For starters, China’s short-term and long-term debt cycles are at different points relative to most of the developed world. Japan, Europe, and the US all have debt levels over 300% of GDP, interest rates close to zero, large central bank balance sheets, and growth well below 5%—none of which is true in China. Of course, as a consequence of global capital flowing more freely, in the future the correlation between Chinese and foreign assets will likely rise somewhat as ebbs and flows in global liquidity begin to have more impact in China. Still, we expect the fundamentally diversifying effects of Chinese assets will persist. All of these factors mean that conditions in China look different than in the countries that dominate institutional portfolios, as shown in the charts below.
Given that conditions are lowly related, it isn’t surprising that asset class returns have been lowly related as well. This means that adding these assets to a portfolio is significantly diversifying.
We’ve also noted previously that China has “fuel in the tank” to ease, should they need to do so. That question, which once seemed like a distant consideration, is now suddenly more front of mind, given recent turbulence around both trade and late-cycle dynamics. While we have our own tactical views on such matters, our core perspective is that it is best to spread one’s bets. The opening of China’s markets and now the inclusion of Chinese bonds will increasingly drive many investors to do just that.
Monday’s Launch of an RMB Oil Future Available to Foreign Investors Is Another Opening Up
Given the news over the bonds, it would be easy to miss another important milestone—the Monday opening of RMB oil futures available to foreigners. China is a huge player in global commodity markets (as illustrated below), so developing onshore commodity futures markets makes sense. China already allows trading of a gold future denominated in RMB.
The parameters of the Shanghai contract are largely similar to crude oil futures currently traded in London and Chicago, with the notable difference that they are denominated in RMB (though foreigners can post margin and take profits in dollars) and have a tighter cap on daily price moves (plus or minus 4%).
RMB futures will allow onshore market participants like oil companies, large consumers, and asset managers (some of whom are currently prohibited from trading commodities, but we expect this will eventually change) to either hedge or gain portfolio exposure to oil without going through the process of converting their local currency into dollars. If onshore investors begin to use oil futures in their investment portfolios, China could become an even more important component of the marginal demand for oil. The chart below on the left shows China’s increasing share of oil consumption, and the chart below on the right shows that a significant share of the global shifts in oil demand come from China. Given this, creating a commodities trading hub in China is logical.
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