Market Snapshot:MSCI A shares inclusion to have much stronger long-term impact than market expects

Small fund inflow, significant implications A shares are finally included by MSCI intoits benchmark emerging markets index after four consecutive years of reviews. A total of222 China A large-cap shares will be included using a two-step inclusion process startingfrom June 2018, representing 0.73% of the pro forma MSCI Emerging Markets Index and0.1% of the pro forma MSCI ACWI Index by Aug 2018 with an inclusion factor of 5%. Ifwe also consider the MSCI Asia ex-Japan Index and the MSCI China Index, based onrespective tracker fund size of US$1.5trn, US$2.8trn, US$200bn and US$14.2bn for thesefour indices, a total of US$15.8bn (~Rmb107.9bn) might be attracted to the A-sharemarket as a result of the inclusion. As of May 2017, the total A-share market cap is closeto Rmb57trn with the YTD daily average turnover of the Shanghai and Shenzhen marketsat Rmb250bn. Despite the relatively small amount of new foreign funds potentiallyattracted by the index inclusion, the strategic and symbolic impact will be significant as itprovides a window for the domestic market to integrate with the global financial system.

    Financials to have highest weighting; securities to benefit most According to our Ashareresearch team, financials will have the highest weighting among the 222 stocks, asthe 19 banks account for 33% of the 222 stocks’ market cap and the 31 non-bank financialstocks account for 15% (using SWS sector categorization). Meanwhile, mining, food &beverage, and construction rank third to fifth, each representing 5-6% of weighting. Thesetop five sectors together represent 64% of the total included A-share market cap, and arelikely to receive the largest foreign fund inflows going forward. While banks have thehighest weighting, investors’ risk appetite for banks may not be great in the short termgiven ongoing financial deleveraging and strengthened regulation. On the other hand,securities carry less risk as outstanding margin loans are currently at the lowest level intwo years, proprietary investment asset allocations are shifting towards fixed incomeproducts, and the average leverage ratio across the sector is decreasing, not to mentionsecurities companies can benefit directly from higher market turnover. Moreover,securities shares’ valuations are close to historically low levels, providing further downsideprotection. We like: 1) large securities companies with comprehensive strengths and abalanced business mix such as CITIC Securities (600030 CH), Guotai Jun’an Securities(601211 CH) and Huatai Securities (601668 CH); and 2) event driven securities namessuch as Guoyuan Securities (000728 CH) and Industrial Securities (601377 CH).

    Potential fund inflow could be much larger than market expects While the initial fundinflow should be relatively small compared with the total size of the A-share market, eitherin terms of market cap or turnover, the market might have underestimated theconsiderable potential of foreign fund inflow over the mid/long-term. Assuming the numberof A shares included remains unchanged, when the inclusion factor increase from 5% to100%, the potential fund inflow would rise to Rmb1.9trn. If we further assume that theeligible stock basket expands such that the adjusted market cap increases by 50%, thepotential fund inflow would rise further to Rmb2.7trn, equivalent to 10.8 days of the currentdaily average turnover. These will not happen overnight, but the potential should not beoverlooked.

    Hong Kong market weighting to decline slightly Among H shares, we believe H-sharesecurities (including their Hong Kong subsidiaries) will be the major beneficiaries giventhe positive effects described above, while the overall Hong Kong market might suffer aslight negative impact due to the A shares inclusion (other things unchanged), as the totalweighting of H shares, red chips and P chips in the MSCI China Index will decline fromthe current 74.5% to 73.4%. The biggest loser will be overseas Chinese shares whoseweighting will drop from 25.3% to 23.8%.

    Risks 1) The increase in the number of A shares included and the inclusion factor fallingshort of expectation in the future; 2) smaller-than-expected foreign fund inflow.