Recently, I have received a lot of replies from SMSF trustees and investors following my notes on asset allocation and global diversification. It appears that readers acknowledge the need for a more diversified approach to SMSF portfolio construction by embracing all the major asset classes.

They also recognise the importance of diversifying the equity weighting within the fund away from a purely domestic focus. To support this view, the latest ATO figures reveal that global shares represent less than 2% of SMSF equity assets.

Asian acceleration

I believe Chinese equities should form an important part of any global equity portfolio. Their performance this year to date alone reinforces that point, but I suspect few Australian SMSF’s have direct or indirect Chinese equity exposure in their portfolios. Let’s just remind ourselves of global equity market performances in Australian dollars 2015 year-to-date.

The Chinese economy is currently in the early stages of an historic economic transition. The government has committed to a rebalancing of economic growth away from an investment-driven model, to a more Western style consumption and services-led economy. That means a policy change away from housing construction as the main driver of economic growth. If investors need any more evidence, the bear market in resources, particularly iron-ore stocks, over the last two years is clear proof. This economic transition has major implications for Chinese equities, which I believe have emerged from a long period of consolidation and into a major long-term bull market.

Shanghai Composite Index (“A Shares”) – 10-year price history

Hang Seng China Enterprise Index (“H-Shares”) – 10-year price history

The credit-fuelled property boom resulted in a massive over-investment in housing and indebtedness by the state controlled banks and provincial governments, which, in turn, had led to a large PE de-rate in Chinese equity markets.

To facilitate the transition to a more traditional economic model, the government recognised the need to open and liberalise capital markets to encourage both the services sector and foreign investment. The government’s financial reforms are aimed at encouraging a market-based system, rather than government policy, to play the major role in capital allocation.

Multi-year PE De-rate in the HSCEI

A focus on capital markets

The key to establishing a market-based system is open capital markets and a healthy, functioning equity market. A deeper, liquid and more open equity market can then act as the conduit to redirect inefficient capital away from housing and property construction. This appears to be working, with falling house prices giving way to a surging equity market. I strongly believe that the opening up of capital markets marks a new growth era for the Chinese economy and one that has very important implications for equity investors.

The government has introduced some important initiatives aimed at facilitating financial reform. Key reforms have included the introduction of the Shanghai-Hong Kong Stock Connect in Q4 2014 and the announcement by the China Securities Regulatory Commission (CSRC) in March 2015 that domestic Chinese fund management companies can buy Hong Kong listed shares via the stock connect without a Qualified Domestic Institutional Investor (QDII) licence requirement. These initiatives have played an important and complementary role in promoting two-way equity flow between both markets.

Later this year, we will also see the introduction of the Hong Kong-Shenzhen Connect, which will broaden the flow of foreign investment into Chinese equity markets.

In addition, there has been much speculation that the central Chinese government is planning a debt swap program to deal with local government liabilities, akin to Europe’s LTRO program. If announced, this has the potential to be the most significant reform to-date and would fundamentally alter investors’ perceptions around the key risk factor that has plagued China’s macro picture in recent years.

The following is a quote from the WSJ (China Readies Fresh Easing to Tackle Spectre of Debt – April 28).

“Under the planned LTRO-like strategy, China’s commercial banks will be permitted to use local-government bonds they purchase as collateral to take out low-interest-rate, three-year loans from the central bank. By doing so, officials at the PBOC will try to direct the banks to lend to small and private businesses, among other sectors favoured by the government. The interest rates on those loans could serve as a medium-term benchmark rate, potentially giving the PBOC another tool to guide interest rates, according to the officials with knowledge of the central bank’s thinking. Currently, the PBOC influences market rates mainly through its benchmark lending and deposit rates, and through the rates in the interbank market where banks borrow from each other.”

The reform process

The financial reform process is also aimed at a development of the IPO and corporate bond markets, given both are critically important to improving capital allocation and reducing the corporate sectors addiction to government bank loans. At a time when corporate debt has reached 120% of GDP, less than 2% of Chinese corporate funding is generated by the equity market. The rebalancing of corporate funding from a reliance on government debt, to a more equity-driven model, has huge implications for the growth in the Chinese equity market.

The other arm of the financial reform process is the government’s commitment to increase foreign access to Chinese financial markets through an open capital account and the intention to allow full convertibility of the currency. This is expected to increase the pressure on the IMF to include the Renminbi in its Special Drawing Rights. In turn, this could facilitate the inclusion of the Shanghai A shares into the MSCI Emerging Markets Asia Pacific Index (MSCI EM) when the index is up for review in June this year. The potential index inflows would represent another leg up for Chinese equities.

Even a partial inclusion in the $US1.5 trillion MSCI EM would generate huge global inflows in anticipation that a full inclusion could happen within 12 months. In the event of a full inclusion, China A shares would account for a massive 27.7% index weighting and represent the highest country weighting by a wide margin. It’s worth noting that the Shanghai A market has one of the lowest foreign participation rates in the world with just 1.5% held by foreign holders (11.5% including HK H shares). This compares to a 25% average for stocks included in the MISC EM index. The Chinese industrialisation theme was huge for the resource stocks but I believe the financial reform process will prove much bigger for equities generally. We are witnessing a historic change in global equity flows and relative positioning.

The wealth effect

The development of equity and debt markets also provides a strong wealth effect for the Chinese economy. It’s important to realise that government policy is aimed at encouraging a transition of household investment from property to the equity market. So far, the results have been stunning. Since late last year, the Shanghai Composite is up roughly 80% and 14.6 million equity accounts have been opened over the period. Even more stunning is the average one-day return for investors on new listings and IPOs is a massive 44% over the same time frame. But even after the stellar performance of the Shanghai Composite, just 10% of the population have equity accounts. Clearly, the upside for Chinese equities is huge.

The political implications of a strong equity market should also not be underestimated. It’s worth remembering that President Xi has implemented an aggressive structural reform agenda, which has centred on a strong anti-corruption campaign. The positive political capital generated by the equity market’s wealth effect only seeks to reinforce the government’s popularity. Of course, this provides a self-fulfilling endorsement of the government’s commitment to the financial reform process.

Unsurprisingly, the meteoric rise in the Shanghai Composite over the last 12 months has resulted in “price bubble” speculation. Therefore, the 10% correction for China A shares last week, the worst weekly performance since February 2009, was welcome news. Our contacts tell us that one of the major reasons for the dramatic sell off was the liquidity drain from 22 IPOs last week. In addition, there were rumours of an increase in stamp duty (since denied) and a threat of tougher margin regulations. In contrast to a belief that any new regulatory issues will derail the current bull market, I believe government is merely trying to cool a red hot market, which should provide a platform more sustainable gains.

In summary, the Chinese economy is being transformed by an historic economic rebalancing. The success of this economic transition remains dependent on a government commitment to structural financial reform. In turn, the successful implementation of the reform process requires open and functioning capital markets in order to promote efficient capital allocation. Don’t underestimate the political will of the government to achieve that goal. The amazing speed of the industrialisation process is a clear example.

A Chinese exposure

China is entering a new phase of economic development. A progression from a fixed asset investment boom (hard commodity boom) to a financial services boom. As a result, a new asset class dynamic has emerged: the transition from a strong property market to an equity bull market. It’s very important to realise that this financial transition is being supported and underwritten by government policy. In one respect, the initiatives of the Chinese government are very reminiscent of the Federal Reserve’s interest rate support for the US equity market through the now infamous “Bernanke put”.

There is absolutely no doubt that Chinese equities will suffer trading corrections due to the current dominance of domestic retail investors. The Shanghai A shares experienced a savage sell off last week. However, I strongly believe that the Chinese equity market has entered a major long-term bull market, which still remains in its infancy. Despite the economic slowdown, China is still growing at 7% per annum. This implies a doubling of its $US10 trillion economy over the next 10 years. At that time, it will exceed the US economy by size. Yet already, Chinese equity market turnover by value has recently overtaken the US for the first time. I think the opportunities are huge. It’s vital that Australian SMSF trustees allocate more funds to global equity markets but particularly China.

As the earlier chart confirms, while the HSCEI is up sharply since November, the forward P/E remains only just above 10x. P/E expansion can, and will, come to Chinese equities and that will be the next leg of the story of Chinese equity outperformance after almost a decade of underperformance.

For Australian SMSFs, arguably the easiest way to gain broad Chinese equity exposure is via the ASX-listed, $580m market cap, AMP Capital China Growth Fund (AGF). Yes, AGF has doubled in recent times, but that doesn’t make me baulk at owning it as the largest portfolio holdings remain cheap. The top 10 portfolio weightings are below.

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.