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China began its economic transformation just 40 years ago in December 1978. Under the impulse of Deng Xiaoping, the country quickly converted to a market economy, beginning an open policy that would transform China into a full-fledged “factory for the world”. Today, this openness continues. On 1 June 2018, certain A - shares, denominated in yuan on the Shanghai and Shenzhen exchanges, were listed on the leading index for emerging markets, the MSCI EM. For foreign investors, this type of IPO promises easier purchasing of Chinese equities. But is this market worth the risk? Swissquote Magazine explains in five points.
1. A market that has become vital
No serious investor could ignore China. As the second largest economy in the world with the second largest stock market in the world (including Hong Kong), China is a giant that has public companies in all industries. The most well-known, such as Alibaba and Tencent, are on the New York and Hong Kong exchanges. But the Shanghai and Shenzhen exchanges are also home to gems that would be a shame to overlook, such as video game maker Youzu Interactive and insurer China Life Insurance. “Chinese stocks have gained credibility and deserve a spot in long-term portfolios,” said Michel Longhini, CEO of Private Banking, Union Bancaire Privée, in an article in the Swiss daily Le Temps.
For a long time, Western investors didn’t trust the Chinese market, as it seemed unreliable. According to figures by the journal Les Echos, foreign investors only held 2% of the local capitalisation, compared to 12% in Malaysia, 14% in the Philippines and 21% in India. To reverse this trend, Beijing has ramped up its initiatives hoping to open its financial markets. Including A - shares into the MSCI index on 1 June 2018 is a first step in this direction. According to estimates from investment bank JP Morgan, this inclusion will attract $40 billion to Chinese markets in the coming months.
And that’s just the beginning. After the MSCI, another stock index provider FTSE Russell announced in September 2018 that it would also include stocks from continental China in its benchmark indices starting in June 2019. According to FTSE Russell, this could attract $10 billion in net cash flow to Chinese stocks. This influx of foreign funds should mechanically raise the Shanghai and Shenzhen exchanges. But one should take heed. “The Chinese stock market is risky,” warned Meng Shen, director of investment bank Chanson & Co. “It’s possible to find great opportunities to make money, but the performance of the main indices remains disappointing. There could be stocks with a 1,000% return over one year, but it’s a gamble.”
2. A calamitous 2018
2018 will likely go down as one of the worst years in the history of the Chinese stock market. Weakened by trade tensions with the United States, the markets collapsed. During the 2018 calendar year, the Shanghai composite index lost 25%, the Shenzhen exchange fell 33% and the Hong Kong exchange was down 14%. That same year, the flagship index of the US markets, the S&P 500, only fell 5%.
For many analysts, low Chinese stocks are a good point of entry into this market. “The recent downturn could be seen as an opportunity to purchase shares of the most solid companies,” said Longhini, CEO of Private Banking, Union Bancaire Privée, in an article in Le Temps.
“The market is currently undervalued,” said Lu Li, analyst at Daxue Consulting. “The current valuation demonstrates the pessimism of investors. But there isn’t much room for more of a drop. I think we will reach the bottom in the third or fourth quarter of 2019. But we can’t predict when the rebound will occur.” This perspective is tempered by Meng Shen, director of Chanson & Co: “I don’t think that Chinese A-shares will recover their entire value in 2019. We might see a slight recovery starting in March.”
This caution can be explained by the uncertainty surrounding relations between China and the United States. After months of a trade war, the two countries declared a three-month truce in early December 2018, ending the mutually-established tariffs increase. While markets responded positively to this pause, the future is still hazy. If in three months, no agreement is reached between Beijing and Washington on topics such as “forced” transfers of technology, intellectual property and cyber espionage, Washington has warned that import tariffs will be increased to 25%. The problem: “A complete trade agreement cannot be made in only 90 days,” said Shen. “I think that the two countries will establish a step-by-step agreement or a framework agreement that will be followed by many negotiations.” In other words, the hatchet won’t be definitively buried in late March.
“The United States and China are playing a dangerous game, because the trade war isn’t good for anyone,” said Shen. “But in this fight, Beijing has less bargaining chips than Washington. The United States is the main export market for Chinese manufacturing companies, so the customs tariff is a massive weapon of destruction against the Chinese economy. If the issue isn’t resolved, pressure on Beijing will increase even more.” Quoted by AFP, Iris Pang, an economist from ING, said “the stock market will largely depend on the progress of these negotiations. If the truce ends badly, retaliation will start up again and the market will sink even further.” “I’m not very optimistic,” said Li. “Trump isn’t a politician; he’s a businessman who is only interested in maximising profits. On the other hand, China has demonstrated that it is no longer afraid of the trade war. Basically, China doesn’t have a lot of options, but the United States doesn’t either.”
3. Sluggish growth
China’s growth slowed throughout 2018, reaching its lowest point in 28 years. According to the Chinese national statistics bureau (BNS), the GDP increased “only” 6.6% last year – a number that many Western economies would envy, but far from China’s standards, as the country is accustomed to seeing double - digit growth annually. For Beijing, the cause of this slowdown is external: “Everyone is worried about the international situation,” said Ning Jizhe, director of the BNS. “There are many variables and uncertainties at play, and that has an impact on our economy.”
Analysts also say China’s internal weaknesses are to blame. Long buoyed by its gigantic local market, with more than 1.4 billion residents, consumption is down slightly. Car and mobile telephone sales, as well as shopping mall purchases, for example, fell in 2018, which could impact companies active in those industries such as auto manufacturer Geely and China Mobile. Furthermore, measures taken by the government to reduce the country’s colossal debt also contributed to the economic slowdown. For 2019, analysts believe growth will continue to slow and settle at around 6%. Nevertheless, there is little chance that growth will stop. The economy can fluctuate “within a reasonable range” but not “fall sharply”, confirmed Prime Minister Li Keqiang in early January. Investing before the Chinese government implements measures to support growth could be a winning gamble.
4. Beijing’s interventionism
Faced with this slowdown, the Chinese government eased its policies in the second half of 2018 and also opted for fiscal measures such as lowering taxes in the hopes of boosting consumption. In 2019, Shen anticipates that the new monetary easing signals will be published during the Chinese People’s Political Consultative Conference (CPPCC).
All these measures should help support the country’s markets. And if that’s not enough, Beijing won’t hesitate to directly support markets as it has numerous times in the past. The problem is that these interventions could lead to distortions and unhealthy speculation. “If you’re an investor and you know that the state will always bail out struggling companies, then you’re betting not only on the companies that will likely create value, but also on government interventions,” said Bing-Xuan Lin, finance professor at the University of Rhode Island.
5. Key industries
In 2015, the Chinese Premier launched the “Made in China 2025” initiative. This government action plan, inspired by the “Germany Industry 4.0” project, aims to support the improvement of the Chinese economy by reducing its dependence on foreign technologies. For example, currently the majority of Chinese smartphones are equipped with chips made by US company Qualcomm. In 2020, Beijing is aiming for products with 70% of the parts and materials coming from China, in 10 key industries. But the plan goes even further: it wants to make China one of the three leading industrial countries in the world by 2049, the centennial of the People’s Republic of China. To achieve this, the initiative has several areas of focus: increasing investments in research and development, improving the automation of Chinese factories and developing strategic industries such as robotics and electronic chips. The industries affected by the “Made in China 2025” plan could be good investment opportunities, since the Chinese government is supporting these significantly. But uncertainty still abounds. The “Made in China 2025” initiative is at the heart of the conflict with the United States.
To calm Uncle Sam, Beijing could replace, possibly as early as March 2019, the “Made in China 2025” initiative with another programme in which the desire to dominate the industrial sector is less of a focus. This approach could benefit China, which is looking to open up further to foreign investors, according to the Wall Street Journal.
While waiting for the China-US saga to end, analysts prefer to look at other stocks. “I recommend Chinese companies active in the gold business, the military industry and new technologies. But only companies that have real R&D resources, as well as intellectual property rights,” said Shen. According to Ben Cavender, analyst at China Market Research Group: “In these uncertain times, people are taking out insurance policies, so this industry has a very promising future. I recommend insurance companies such as China Life Insurance.”
THE NEW SILK ROAD
Launched in 2013 by President Xi Jinping, the Silk Road Economic Belt (Belt and Road Initiative) is an infrastructure project estimated at $800 billion, which is unprecedented. This project aims to physically connect China, Southeast Asia, Central Asia, Europe and Africa via roadways, railways and maritime routes. According to a report from UNCTAD (United Nations Conference on Trade and Development), the economic belt envisioned by Beijing is a gigantic market of 68 countries, with a total population of approximately 4.5 billion (62% of the global popu-lation) and a total GDP of around $23 trillion, or one-third of the global economy. This immense project could have a considerable impact on markets, benefiting the transport of raw materials and goods in particular. “The new silk roads are probably the biggest initiative that you’re not paying attention to,” said Robert Friedland, executive co-chairman of mining group Ivanhoe Mines, at the FT Global Commodities Summit.
In terms of freedom of expression, China stands out for its repressive policies, which have significant consequences for its markets. In March 2018 for example, Beijing decided to suspend the release of new video games in the country. This was a catastrophe for makers such as Tencent, which lost one-third of its value during that time, as well as Youzu Interactive. While the ban ended in December 2018, this type of abrupt decision isn’t something that reassures investors. Many other companies could be sanctioned as well. In 2017, the three most popular social networks in China – WeChat messaging, microblogging site Weibo and search engine Baidu – were under attack from the government because they allegedly posted “illicit content” that “put national security at risk”.