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As China marks its new year, is it time to crow about Chinese equities?

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As China prepares to celebrate the year of the Fire Rooster, the question on many investors’ lips is ‘will Chinese equities rule the roost in 2017?’

The last year the Fire Rooster fell was in 1997, a year which saw the formation of the European Economic Community through the Treaty of Rome. Some 20 years later, as the European Union faces a possible crisis in the form of the rise of populism in a year of general elections and as the world gets to grips with Donald Trump’s new administration, what are the prospects for China amid all the political turmoil in the developed world?

After a period of staggering economic growth, China has been making the headlines for all the wrong reasons over the last couple of years, with the main concerns revolving around its slowing GDP. However it remains the second largest economy in the world behind the US and its official growth rate in 2016 was 6.7%,

Tilney Bestinvest’s managing director Jason Hollands notes while this is sharply slower than the 10.4% seen in 2010, it still outpaces those of mature, western developed market economies such as the UK and US.

As such, when putting this economic growth alongside China’s huge population and its rapid industrialisation, he says it is easy to consider it a ‘must have’ in an investment portfolio. However he notes there is more to China than its economic growth.

Markets and GDP are not the same

Today the Shanghai Composite Index is languishing some 50% below its all time peak of 6,093 which it reached in October 2007.

“It’s important not to confuse GDP growth with stock market opportunities, as the relationship is not a simple one,” says Hollands. “There has been no discernible correlation between Chinese GDP returns and those of its highly volatile markets. After all, you cannot invest in GDP and in the case of China much of its economic growth is uninvestable.”

Instead Hollands says what you can invest in, to a degree, are the securities markets. However he notes these have a very different make-up to the Chinese economy and what makes up its growth figures. For example some 27% of the MSCI China Index is represented by financial companies and 32% by IT companies.

At the same time, despite its huge economy, versus the US and UK which make up 53% and 6.2% respectively of the FTSE All-World Index, China makes up just 2.2%.

Risks and opportunities in China

Fidelity’s Dale Nicholls, who manages the Fidelity China Special Situations investment trust, says at this stage it remains difficult to decipher between rhetoric and reality when it comes to Trump.

With this in mind his fund continues to be heavily invested in those Chinese companies which are set to benefit from the growth and development of the domestic consumer, as opposed to those focused on overseas markets which could soon become tougher to access.

“There remains significant growth potential in companies related to consumption and the changing ways in which people consume,” he says. “Many categories of consumer goods in China are still under penetrated relative to other countries.”

Instead for Nicholls the biggest risk in China remains the growth in credit, which while there have been signs of it slowing, he says more progress needs to be made. Indeed AJ Bell’s investment director Russ Mould notes that credit growth and loans offered to domestic Chinese consumers by the four largest state-owned commercial banks grew 9% in the fourth quarter of 2016, although he adds this is a marked slowdown from prior years.

“Most indicators suggest that Chinese growth is back on track for now,” says Mould. “However its reliance on fiscal stimulus and debt remain a concern, while much may also depend on how its currency, capital market reforms, and Trump interact.”

How should you invest in China?

For those looking to incorporate China specifically into their investment portfolios, Chris Stevenson, head of product investing at Barclays, says one of the best ways is to invest in UK-based funds which have partial or exclusive exposure to the Chinese market.

Stevenson says the three key benefits of investing via a UK-based fund are:

1- Expertise: An investor will benefit from a fund manager’s in-depth understanding of the market.

2- Economy of scale: Investing in a fund spreads an investor’s money across a wide range of underlying investments, spreading the risk without having to pay the underlying transaction fees.

3- Ease and convenience: Investing in a single fund is a simple process. An investor can take advantage of the rich and informative content produced by their direct investing broker to find the right fund for them.

For those who want to adopt a passive strategy, Stevenson suggests exchange traded funds (ETFs) which can usually mirror the performance of a particular Chinese index.

However when it comes to active funds, Hollands cautions against investing in single-country China funds. He says: “For most investors, exposure should be through broader Asian and emerging markets funds (such as Stewart Investors Asia Pacific Leaders, Schroder Asia Pacific or Fidelity Emerging Markets) that can partially allocate to China and weigh up the case against other opportunities, such as India, rather than specialist China funds that are going to be more exposed to the risks.

“Similarly, it is also the case that investors do not need to be exposed to companies listed on China’s local stock markets to get a piece of the action as there are plenty of developed market companies (and funds) that are tapping into China’s potential, but which are on liquid exchanges such as London where high standards of corporate governance and transparency are required.

UK-listed firms such as ARM, Burberry, Intertek, Standard Chartered and Unilever all have exposure to China and global funds, such as Scottish Mortgage Investment Trust, include holdings in key ‘new China’ plays such as Tencent, Baidu and Alibaba.”

So the message seems to be, whatever the surprises the Year of the Fire Rooster brings, it pays to tread carefully when it comes to China funds.