
Over the past four years, China has made significant efforts to further open its capital markets, and in February, index provider MSCI announced its decision to increase the weighting and breadth of China A-shares exposure in its emerging markets index, as well as in its China index and other regional indices. The three-step implementation process will see the inclusion factor go from 5% to 20% in total by November 2019.
These increases are naturally of great interest to investors but to a large extent, merely scratch the surface of opportunity in the latest iteration of China’s growth story.

With the idea of a dedicated allocation to China receiving more and more consideration from institutional investors globally, many are drilling deeper into the type of exposure they have, going beyond adding China for its own sake and looking for more growth opportunities. As they look for differentiation with respect to their China holdings, China small entrepreneurial companies – which now constitute the world’s largest small cap market – are emerging as powerful engines of growth.
Where to Invest in China: New Sectors Drive Earnings Growth
The earnings story in China today is about changing market composition. The old industrials are becoming less important while the new industrials are taking on a bigger role from a macro perspective. As bottom-up, fundamental investors, at Matthews Asia, we see the emergence of sectors such as IT, pharmaceuticals and consumer discretionary. The composition change is important for the earnings turn, and we believe earnings are on more solid footing than in previous cycles. Earlier, we saw the earnings cycle in China as cyclical in nature – now, in part due to consumer spending, we are beginning to see less cyclicality in the cycle.
We believe a dedicated allocation to China can help investors fine-tune and recalibrate how they gain access to the world’s fastest-growing economy, while improving global diversification. As a core portfolio holding, China equities can comfortably sit alongside such portfolio staples as U.S. and EAFE (Europe, Australasia and the Far East) investment strategies. Looking ahead, we expect earnings growth in China to be increasingly driven by innovation and consumer-driven sectors. As the spending power of China’s middle class continues to grow, sectors and industries such as health care, travel and leisure, and consumer services will play a much greater role in fueling China’s economic engine. Accordingly, we believe that an effective way to capture the future of China’s growth is through a dedicated allocation to China that employs an active approach to security selection. Given China’s growth potential, investors may benefit from considering China strategies that are forward-looking by design, seeking to capture China’s future, rather than its past.
With just a modest boost to credit, the Chinese government succeeded in strengthening investor sentiment and stabilizing real economic activity during the first quarter of the year. The growth rates of income, retail sales and industrial production were stronger than in the fourth quarter of last year, without a dramatic stimulus. The central bank has signaled that it is comfortable with growth prospects for the coming quarters and wary of unnecessarily raising the national debt burden, so any additional stimulus will likely be even more modest.
In my view, the biggest weakness in China last year was poor sentiment among the country's entrepreneurs and investors, despite reasonably healthy macro activity and strong corporate earnings growth. This provided the government with an opportunity to take several inexpensive steps to boost sentiment.
As expected, the state-controlled banking system increased credit flow during the first quarter, but – also as expected – the increase was modest. The growth rate of outstanding augmented total social finance (TSF), the most comprehensive metric for credit in the economy, accelerated to 11.3% year-over-year (YoY) in March 2019, up from 10.8% in February and the first month over 11% growth since September 2018. But, to put this into context, the 11.3% pace in March was slower than the 12.6% pace in March 2018; the 14.6% in March 2017 and 16.6% in March 2016.
Another way to illustrate the modest scope of the credit stimulus is to look at the gap between the growth rate of augmented TSF and the growth rate of nominal GDP. In the first quarter of 2019, the gap between the growth rate of credit and of nominal GDP was 3.5 percentage points (pps), roughly the same as the 2.3 pps gap in Q1 2018, and significantly smaller than the 9.7 pps gap in Q1 2016. To put this into further context, in 2009, as Beijing was responding to the Global Financial Crisis, the gap was 26.8 pps.
It is also worth noting that the government has not abandoned its financial sector de-risking campaign. Off-balance sheet, or shadow credit, declined 10.3% YoY in March, compared to increases of 5.5% in March 2018 and 11.5% in March 2017.
Beijing also refrained from turning on its traditional public infrastructure stimulus taps. Infrastructure investment rose only 4.4% in the first quarter, compared to 5% in Q4 2018 and 13% in Q1 2018.
See more from Andy Rothman on further steps the Chinese government took to strengthen investor sentiment, and what the effects of the effort have been.
The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Past performance is no guarantee of future results. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The information contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. This report is for informational purposes and is not a solicitation, offer or recommendation of any security, investment management service or advisory service.
“It is often forgotten that China is the strongest dividend story in Asia,” Zhang says. “H-share payouts have multiplied by a factor of 14 in the past 20 years.”
Chinese companies paid out just $8 billion in dividends in 1998. By 2017, that figure had risen to $114 billion.
Across Asia, many listed companies are aligning their dividend strategies more closely with shareholder needs, aware that a strong and sustainable payout reflects good underlying capital allocation by company management. Chinese businesses are no different and have led the dividend revolution in the past 10 years. Annualized dividend growth was 14.6% in the decade ending 2017, significantly ahead of South Korea (8.6%) and the rapidly emerging economies of Thailand (7.5%), Indonesia (10.2%) and the Philippines (7.8%).
Matthews Asia has significant experience investing in dividend-paying companies in Asia for over 25 years.
“We run a balanced portfolio of stocks that collect dividends from companies from various sectors, industries and market capitalizations to ensure both stability and long-term growth in dividends,” Zhang says.
The dividend lens
To ascertain the ability of a company to pay growing dividends, Zhang and his team start with fundamentals. They seek companies with strong financials, solid balance sheets, low financial leverage, and improving cash flows and dividend payout ratios.
“Dividends are a lens through which we identify high-quality, financially healthy companies with prudent capital allocation policies,” Zhang says.
Zhang notes that dividends can be a better indicator of business performance than reported accounting growth. A corporate commitment to dividends is an incentive to management to be highly disciplined in the returns they generate on capital invested.
Outlook for dividend growth
Zhang believes Chinese companies will continue to deliver low-teens earnings growth over next two years and that dividend growth should at least be in line. He thinks some of SOEs (state-owned enterprises) might even raise their payout ratio this year to generate revenue to offset the Chinese government’s aggressive tax cut.