T

he core message of the recent Morgan Stanley Blue Paper “Why We Are Bullish on China” is that Chinese equities can continue to outperform emerging-market equities in the future, as they have done for some time.

Cumulative outperformance over the last 15 years for MSCI China versus MSCI EM has been 5,000 basis points, or around 3 percent per year. China has also outperformed emerging markets over both five and ten years, and not by small amounts. Total returns have averaged 5 percent per year in US dollar terms over those periods, and 13 percent per year over the last 15 years.

For us, being overweight China equities in our recommended allocation to clients investing in the EM space is not unusual. Our structural bullishness in the 10 years I have covered China equities at Morgan Stanley is starkly different from that of the consensus amongst global investors and even EM specialist managers, who have been and remain underweight China.

Indeed, the latter group is running a near record underweight on China versus the benchmark of 500 basis points currently, and at no point in the last 15 years have EM specialists ever been anything but underweight China.

So what is it that the consensus is so worried about and what are they missing which we think is positive? In our view, consensus thinking on China has always been too caught up in the macro debate, particularly in relation to debt sustainability, excess capacity and more recently foreign exchange risk.

Consensus has been insufficiently focused on identifying the sources of China’s outperformance, which lie in the market having had a materially higher return on equity (ROE) than the EM average over the cycle, and hence higher earnings growth in US dollar terms.

We believe the roots of that phenomenon lie not so much in an economy that is becoming more leveraged, though it has, but in an equity market that is evolving faster than the overall economy by becoming more consumer- and services-oriented as well as more private sector-driven.

In 2005 only 5 percent of MSCI China’s market capitalization was in non-state-owned sectors. By 2016 it was almost half, and we project in our Blue Paper that non-state-owned firms will be 70 percent of market cap by 2020. The non-state-owned firms, including household names like Alibaba and Tencent, have higher revenue growth and less leverage than their state-owned peers and have substantially outperformed the market over the cycle as they operate predominantly in IT, Consumer and Healthcare, which are the sectors that we argue in the Blue Paper will continue to drive China’s journey to high-income status.

In our Blue Paper we identify 50 Chinese firms in these New Economy sectors that are “unicorns,” that is, they achieved private market valuations of over US$1 billion prior to their initial public offerings. That is more than the number of unicorns in the rest of the world (excluding the United States) put together.

Going back to our current view on the market, we would highlight the following. MSCI China is trading at around a 5 percent valuation premium to EM, on 1.6x trailing price/book value, and yet with ROE at 12 percent is delivering a 20 percent ROE premium.

We have similar forecasts for China and EM of low teens earnings growth in 2017, in both cases coming off two bad years for earnings, but our higher forecast return for China comes from our expectation of relative multiple expansion, from around parity now to a 10 percent premium by the end of the year.

The catalyst for this re-rating is not, we suspect, any rapid reversal of foreign investors’ underweight stance on China, though we think that will reduce, but much increased Southbound Connect flows from the Chinese mainland into Hong Kong. These flows are increasingly institutional in nature and are taking advantage of discounted H share valuations relative to A shares for dual-listed names.

Quality Hong Kong-listed names such as Tencent, China Mobile and AIA, which are not listed onshore, also offer diversification benefits for domestic investors. These southbound flows are running at close to $1 billion per week in the year to date, and we expect around $30 billion to $50 billion cumulatively for this year in total.

The broader context for mainland China equities is that investors are rotating away from bonds and property back towards stocks with an improving earnings growth outlook amidst higher inflation and demand-side property control measures. Meanwhile, the domestic regulator has followed through on its August 2015 plan to allow domestic pension funds to invest up to 30 percent of their net assets in equities (versus zero previously).

Mandates were awarded last December by the National Pension Fund to 21 asset management companies to invest in equities, and these funds have begun to be invested in the local equity market as of last month.

In conclusion, the outlook for China equities is bullish from both a structural and cyclical perspective. We believe valuations are reasonable, earnings growth is recovering and long-term institutional capital is increasingly moving into the market.
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The writer is chief Asia & emerging market equity strategist at Morgan Stanley.