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Eric Varvel: "Benefit from China's growth trajectory"

Despite the sheer scale of the Chinese economy, international investors are still under-allocated in China. Eric M. Varvel explains why.

Mr. Varvel, while China has become integral to the global economy, has that been mirrored in China being a critical component in the portfolio of global investors?

China is already the second largest economy in the world with a GDP of approximately USD 12 trillion. The Chinese equity market is the second largest and the local bond market is ranked third in the world. Even with the scale and growth of China, international investors are significantly under-allocated. This is beginning to change. The inclusion of China A-shares in MSCI indices and strong market performance is stimulating increasing interest and urgency for investors to start the process of right-sizing their geographic allocations. A shift in the geographic composition of portfolios towards China is supported by improving regulatory transparency and corporate governance. We also think investing in China makes economic sense for investors with attractive valuations relative to earnings growth, higher yields and a lower correlation to developed markets that we believe will enhance the risk-adjusted returns of a global investor's portfolio.

The Chinese equity market is the second largest and the local bond market is ranked third in the world.

Eric Varvel

The majority of Chinese companies are only traded as "A-shares" on the mainland stock exchanges of Shanghai and Shenzhen. How do these exchanges differ from their counterparts in the US and Europe?

There are important differences that have made it more challenging for global investors to gain access to most Chinese companies. As a result, the A-shares listed on the Shanghai and Shenzhen stock exchanges are primarily held by domestic investors. The combined market capitalization of these exchanges has grown to more than USD 7 trillion. The Chinese government and regulators have been making meaningful changes to reduce the barriers of entry for global investors. Over time, the internationalization of the RMB and capital markets in China should translate into the Shanghai and Shenzhen Exchanges operating similarly to their global peers.

A-shares are on the verge of being incorporated into the MSCI indices. What will this development mean for investors?

 In June 2018, a subset of large-cap A-shares will represent 0.73% of the MSCI Emerging Market indices. We believe the A-share allocation will increase significantly within the EM indices and eventually be included in the global indices. Passive index-tracking and benchmark-oriented strategies will steadily and predictably increase their allocation to China in line with these changes. This is already causing global investors to fundamentally reevaluate their exposures to A-shares and local currency bonds.

China is maturing like other countries that have gone through an industrial revolution.

Eric Varvel

There has been a lot of attention around Chinese internet companies and valuations seem to be expensive. What is your view on whether these companies represent an opportunity or a risk for investors?

China has a thriving technology sector that has become quite pioneering, particularly in the adoption of mobile technologies. Unlike companies in the US and Europe that have already globalized, China's technology companies are just beginning to expand geographically and people are going to be surprised by their innovation, competitiveness and eventual penetration. There is tremendous potential in many of these companies, but you also have to be thoughtful about valuations and potential risks.

China no longer wants to be just the "world's factory." It is currently pursuing the China Manufacturing 2025 plan, which involves a complete technological overhaul of the domestic manufacturing industry. How will the implementation of this plan impact on the global economy?

With rising labor costs and an aging population, China may no longer produce the cheapest shoes or T-shirts. China is maturing like other countries that have gone through an industrial revolution. The focus on education and quality labor is facilitating competitiveness in both higher-value manufacturing and other sectors like technology as we discussed. The quality of growth has improved as China continues its transition from an export and investment-led economy to a consumption and services-driven economy. We believe this is positive for sustaining global growth, but it will also pose challenges for international companies that are competing in these businesses. Ultimately global trade and competition are good things.