The Weekly Update

Last week, President Trump withdrew the US from the Trans-Pacific Partnership (TPP) which had taken the Obama government two years to negotiate. The TPP included 11 other nations in a free trade agreement linking countries that account for approximately 40% of global GDP. Trump, during his campaign, claimed the current TPP and NAFTA agreements were unfair to American industry, adding that workers appear to have opened the door for China to take a major role in trade within the region.

Senator John McCain of Arizona said the US withdrawal ‘will create an opening for China to rewrite the economic rules of the road at the expense of American workers’. Next month in Japan the trade deal being promoted by China, The Regional Comprehensive Economic Partnership (RCEP) which includes 16 nations has its next round of talks and includes Japan, South Korea, Australia, New Zealand and India.

Former US trade representative for China affairs said ‘It’s a giant gift to the Chinese because they can now pitch themselves as the driver of trade liberalization.’ Chinese President Xi Jinping has already started to position China to take advantage and had anticipated Trump’s move on trade. Just last week in Davos at the World Economic Forum he described trade protectionism as ‘locking oneself in a dark room’. Xi has made trade a cornerstone of his presidency endeavouring to expand trade ties with neighbours and has put in place a massive infrastructure project opening up old trading routes to the Middle East and Europe. In fact the first direct train from China to the UK arrived in London last week, re-opening the old (2,000 year old) Silk Road route; which was previously used to carry goods between Asia and Europe. After a 7,500 mile, 18-day journey the Chinese freight train delivered  ~GBP 4m worth of clothing and other goods to Barking, East London.

Not only does it look as if China will benefit from the US withdrawal from the TPP, China will also benefit from the long awaited inclusion of China in the major bond indices. Bloomberg/ Barclays Fixed Income Indices last week announced new parallel global indices that include China RMB denominated securities.

Take two influential indices: MSCI Emerging Market Index in stocks and the Bloomberg Barclays Global Aggregate Bond Index for bonds, each comprising nearly 25 countries. Both are typical to the universe of indices and as such are systematically underweight in China. For although China dominates the EM space (with the second largest stock and third largest bond market in the world) its capital mobility restrictions, quotas and transparency hinder it from being included on a level proportional to its economic significance.

As we have previously compared: ‘China‘s GDP is over 7x larger than South Korea’s which currently accounts for over 15% of the MSCI EM Index’. Currently at 26.8% China’s weighting in the MSCI EM index could rise to 27.8% with a partial inclusion which was postponed last June. This may still be on the cards for this year but China’s recent increase in capital controls make it less likely. Further into the future it has the potential to reach over 40% will full inclusion of China A-Shares (alongside already included China and China overseas shares) should the quota systems and capital mobility restrictions ever be fully abolished. With around $1.5tn benchmarked to the MSCI EM Index and plenty more active and passive money influenced by this and similar indices this transitional trend could bump up international investment to both China’s stock and bond markets.

But whereas equity investors will have to wait a few more months for the MSCI decision, the Bloomberg Barclays Indices (which have become increasingly popular since acquired by Bloomberg in December 2015) have decided to create a parallel ‘Global Aggregate Index + China’ which would include onshore Chinese government bonds whilst keeping their Global Aggregate Index unchanged. This allows investors to decide to follow either or both going forward.

Such ‘transition indices’ should be seen as a positive step for the Chinese government who continue to suggest further key reforms are imminent. It also represents an opportunity for international investors who currently only hold around 2% of both the mainland stock market and onshore interbank bond market according to the Financial Times. Should other major index providers follow suit (JP Morgan, MSCI and Citigroup expected to make announcements in the next few months) investors should consider their allocation to China in general and make the necessary adjustments before passive investments are forced to follow any potential index adjustment. Even if China doesn’t make the cut this year its disproportional economic magnitude suggests that Chinese stocks, bonds and currency should eventually but inevitably constitute a greater proportion of international portfolios.

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