What Will MSCI’s Latest Chinese-Centric Metamorphosis Look Like?

China’s Economy is Open: You are Now Free to Do as They Tell You

MSCI announced last year that it will be adding mainland Chinese stocks (A-shares) to its Emerging Markets Index for the first time, ever. History shows that a country’s market usually pops after it joins MSCI’s elite club of emerging markets.

Skyline of modern buildings in Beijing’s Central Business District at dusk. Expect more buildings like this popping up across China’s major cities. (Shutterstock)

China is one step closer to joining the global financial elite

Four years ago, China began negotiations with MSCI to join the Emerging Markets (EM) Index.

They made a deal: if China removes its restrictions on foreigners owning stocks, MSCI would give them a seat at the big boy’s table.

China gradually completed its promise and in June 2017 the announcement came. MSCI declared it would be adding 222 large-cap A-shares from China’s Shanghai and Shenzhen Stock Exchanges to the EM Index. The official inclusion would launch in June 2018.

This decision is both historic and momentous.

According to MSCI, of the US$1.6 trillion that tracks the EM index, around US$272 billion, is expected to reallocate to Chinese mainland shares.

But that’s only considering MSCI. In reality, an estimated US$1 trillion could pour into China’s market. This capital inflow will come from MSCI as well as other indexes and funds that track MSCI.

The new power dynamics

Besides money, China will also receive power from the verdict.

Right now, only Hong Kong listed Chinese companies (known as H-shares) and overseas-listed Chinese mainland companies (like Alibaba and Baidu in the U.S.) are allowed in MSCI’s EM Index.

Both currently account for 26 percent of the index’s total. But by June 2018, nearly 29 percent of the index will be allocated to China, excluding the already cross-listed mainland shares.

And in the months following the initial inclusion in June that number should increase – substantially. It’s estimated that Hong Kong shares and Chinese stocks will account for 40 percent of the EM Index by 2018’s end.

As you can see below, following full inclusion, China will occupy a little less than half of the entire index! Major emerging economies like Brazil, Korea, and India will be dwarfed.

In 2018, previously unavailable Chinese stocks will be exposed to emerging markets and global indexes for the first time. You can be certain these shares will be selling like hotcakes.

Does this all sound too good to be true?

It may seem like China’s government is bending over backwards to please foreigners. But don’t be deceived.

Beijing being sympathetic to foreign woes is all part of the government’s master plan. Increased levels of foreign investment will kick-start China’s economic slowdown and fuel growth. Remember, China’s stock market is a fake.

Big dreams meet big expectations

Getting bumped up by MSCI from the Frontier Index (mainland stocks’ current position) to the Emerging Market Index is a rare privilege.

In fact, in the last decade, only three countries have been added.

In 2013, MSCI announced that it would be upgrading the United Arab Emirates and Qatar to EM status. Look at how their markets responded below. Pretty spectacular.

Then in 2016, MSCI added Pakistan to its special EM club. The MSCI Pakistan Index reacted to the positive news by increasing 25 percent.

MSCI’s China announcement should offer similar upticks in performance.

So, how can A-shares benefit an emerging market portfolio?

Think ahead and consider A-shares new-found availability, legitimacy, and access to greater capital. They will make solid additions to any emerging market portfolio.

Even adding just 20 percent MSCI China’s A-shares to your portfolio would potentially increase your portfolio performance (by adding 85bps alpha annualized over 10 years).

Additionally, volatility could decrease as well. This will foster a more attractive risk-adjusted return.

Take a look at the figure below to see how A-shares could improve your portfolio.

Now let’s think even bigger.

Listed below are the top twenty investment funds that track the MSCI EM Index (known officially as MXEF).

These funds, and every other fund tracking MSCI, will need to put capital towards A-shares starting in 2018. If you can imagine a dam of money cracking open and flooding into Chinese markets, well that’s exactly what’s going to happen.

An inflow of capital to A-shares, alongside companies obtaining higher trade volumes, will cause investment opportunities to multiply in China.

Let’s see how this will play out. Below are the top ten A-shares stocks with high volatility and the largest market cap. Keep an eye on these stocks as they will have the greatest gains from being added to the MSCI EM Index.

The EM index is going to serve as China’s investment portal.

This is all part of China’s economic agenda. On its own terms, it will open its economy and meet domestic demands for increased capital.

Chinese companies will benefit and Chinese stocks will become more legitimate and more desirable. All the while, the government will preserve its command over the economy. It’s a win-win situation … for China.

Of course, intelligent investors can also get great gains from China’s sly game.

In the next daily we’ll dive headfirst into China’s thriving tech industry. We’ll shift through all the rubbish and help you find golden stock picks in China’s “new economy”.