OREANDA-NEWS. On 26 May, FTSE Group made the announcement to include China stocks in two new emerging-market indexes. Two transitional indexes that include China A-shares will be launched – a staggered approach that lays the foundation to bring local Chinese shares into the FTSE global emerging markets benchmarks.

During the extended trading session on 26 May, SGX FTSE China A50 Index Futures hit 15,000, the highest level since the global financial crisis, following the FTSE announcement.

The new indices, named FTSE Emerging Markets China A Inclusion Indexes, will initially have a 5% weighting for China A-shares. That will rise to 32% when Chinese A-shares become fully available to international investors.

The FTSE announcement comes ahead of a much anticipated 9 June decision by rival MSCI Inc. on China A-share inclusion. Presently, China-listed equities have not been included in the MSCI indices. However, this could change as Beijing continues to press its case with money managers and index providers.

Templeton Emerging Markets Group Chairman Mark Mobius, who was against inclusion as recently as March, was quoted in an interview as supporting the inclusion of Chinese shares in MSCI indices and said his funds are now buying yuan-denominated shares.

GaveKal Dragonomics' Chief Executive Officer, Louis-Vincent Gave, also believes the China equity rally still has legs.

“The global investment community is under-exposed to Chinese stocks and bonds, but will be compelled to increase their exposure over the coming two or three years as Chinese financial assets begin to be included more fully in the global benchmarks that passive – and many active – institutional investors track,” he said.

Up till now, it has been a liquidity-driven market with Chinese retail investors spearheading the bull run. However, the next wave will likely involve international investors.

Chinese Equities Extend Winning Streak; Domestic Reforms Fuel Charge

The magnitude and duration of the rally in Chinese equities continues to silence sceptics.

China’s CSI 300 Index surged above 5,000 for first time since 2008, while the FTSE China A50 Index soared past 14,700 earlier. In terms of market capitalisation, China’s stock market is the second-largest in the world, with turnover exceeding that of US equities on a number of occasions.

Hopes of further stimulus have helped to fuel Chinese stocks. In addition, the swift pace of reforms has continued to attract both domestic and international interest, adding to upward pressure on stock prices.

The Chinese media reported that the China Financial Futures Exchange (CFFEX) will soon launch the country's first-ever stock index option, broadening the range of available hedging tools as the government quickens the pace of financial market reform. This comes on the heels of the launch of options trading on the China 50 ETF in February.

The first set of stock index options will be based on China's CSI 300 and SSE 50 indices, as well as the small-cap CSI 500 Index.

Correlation

(15 May 14 - 18 May 15)

 FTSE China A50 Index CSI 300 Index SSE 50 Index HSCEI Index
FTSE China A50 Index 100% 94.40% 99.50% 73.80%

Another catalyst for the bulls is the impending link-up between the Shenzhen and Hong Kong stock exchanges, which could take place later this year.

The aggregate investment quota for the Shanghai-Hong Kong stock connect programme will be abolished when a similar equity link is established with the Shenzhen bourse, Ming Pao, the Hong Kong newspaper reported, citing unnamed sources.

Reforms also took another leap forward when regulators in China and Hong Kong announced on 22 May they would allow cross-border sales of funds on 1 July, thereby widening access to financial markets and capital in the world’s second-largest economy.

The initial quota will be a total RMB600 billion (US\$97 billion), split evenly between China and Hong Kong.

At the initial stage, only bond funds, general equity funds, mixed funds, unlisted index funds and physical index-tracking exchange-traded funds would be eligible under the scheme, regulators said in the statement.

Two-way funds access between China and Hong Kong could invigorate both markets with a slew of investment products.

H-shares Play Catch-Up

Given the market’s recent surge, it is easy to overlook the fact that Chinese equities, until the launch of the Stock-Connect program, had been in the doldrums. Since the 2008 financial crisis, while US equities have gained on the back of the Fed’s looser monetary policy, stocks in China have languished prior to November.

Even with their recent meteoric performance, the largest China A-share companies (as represented by the FTSE China A50 Index) are trading at a price-earnings ratio of around 13 times, compared with 19 times for the S&P 500 Index.

Table: Equity Indices

Name PE (2015) % ROE
FTSE China A50 Index 12.98 17.41
S&P 500 Index 18.79 13.31
FTSE 100 Index 22.22 9.52

Hong Kong H-shares are even more undervalued, hovering at two-thirds the value of their Chinese counterparts over the past six months.

However, a reversal started at the end of March as the value of H-shares advanced at a faster pace versus A-shares, with the Hang Seng AH Premium Index plummeting from 132.82 on 31 March to 120.61 on 13 April.

The Hang Seng AH Premium Index tracks the average price difference of A-shares over H-shares for the largest and most liquid Chinese companies with both A-share and H-share listings (“AH Companies”). A value of over 100 would indicate a price premium of A-shares to H shares and a value of below 100 means H-shares are trading at a premium versus A-shares. A value of 100 means A-shares are trading on par with H-shares.

When regulators gave the green light to expand the types of funds eligible to access the Stock-Connect program, H-shares moved higher on speculation Chinese mutual funds would buy Hong Kong equities.

Nonetheless, on 16 April, news on a series of reforms to be initiated on China’s cross-border investment market propelled A-shares higher. These reforms will include the introduction of daily repatriation for QFII funds and a US\$5 billion quota for QFII licence holders.

At the same time, spreads between the SGX China A50 Index Futures front- and second-month contracts started to narrow sharply from the middle of May. Daily average volume of China A50 Index futures jumped to 429,552 (as at 30 April 2015) – a 35% increase from March.