Chinese stocks just got a whole lot more important for global investors

MSCI, the company that compiles some of the world's most closely followed share indexes, said Thursday that it will quadruple the amount of Chinese stocks in its key benchmarks this year.

Trillions of dollars of investments are based on MSCI's indexes. The New York-based company's decision to boost the inclusion of Chinese shares could draw an extra $85 billion into China's stock market, the second biggest in the world, according to JPMorgan analysts.

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Many analysts and investors welcomed the move, saying it could boost confidence in Chinese stocks and encourage companies in the country to become more transparent. But they also advised caution for anyone tempted by MSCI's announcement to rush into mainland China's volatile, underdeveloped market.

"Many global investors will view China's onshore market as a bit of a basket case," Nicholas Yeo, head of China equities at investment firm Aberdeen Standard Investments, said in a commentary on the MSCI decision.

About 80% of trades in China's $8.5 trillion stock market are made by mom-and-pop investors, rather than the big institutions that dominate the US and European markets. This can make Chinese stocks susceptible to unpredictable swings.

"Local retail investors [are] more easily swayed by the latest headlines than the earnings prospects," Yeo said.

A stock exchange hall in the Chinese city of Hangzhou. Chinese markets are dominated by mom-and-pop investors.

Wild swings

China's stock market earned a reputation in recent years for wild surges and brutal sell-offs, most notably in 2015 when many companies froze trading in their shares as prices tumbled, trapping investors' money.

Last year, China's benchmark Shanghai Composite index (SHCOMP) plunged more than 25% as fears mounted over the country's economic slowdown and its trade war with the United States. But the index has surged about 20% since early January, putting it in bull market territory.

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Chinese stocks could now be overvalued given that the economy is still weakening, according to some analysts.

"Stock prices risk becoming increasingly unmoored from the fundamentals, which are generally downbeat," Julian Evans-Pritchard, senior China economist at research firm Capital Economics, wrote in a note to clients Friday.

Disappointing earnings growth among Chinese companies raises questions over "how long the current rally can be sustained," he added.

Access to Chinese stocks is also tightly controlled by the government.

Unlike other major global markets, investors either have to apply for a trading quota from Chinese regulators or buy and sell through the Hong Kong market.

MSCI said in its announcement Thursday that Chinese regulators have taken a number of positive steps, including improving access to the market. It noted a "significant reduction in trading suspensions in recent months."

'Compelling reasons' to view China more favorably

Investors hope the greater inclusion of Chinese stocks in MSCI's indexes will push firms to step up their game.

"This should be a good incentive for local companies to increase the transparency of their reporting practices and to adopt strategies that more firmly consider shareholders' interest, as companies with better corporate governance are more likely to be owned by foreign investors," Eric Moffett, an Asia-focused portfolio manager for investment firm T. Rowe Price, said in a market commentary.

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MSCI first started adding Chinese shares to its indexes two years ago after previously rejecting them. This week's decision means 20% of Chinese stocks will eventually be included in MSCI's index compared with 5% at the moment. Just over 3% of MSCI's Emerging Markets index will now be dedicated to Chinese shares.

Many investors approve of the move, despite the Chinese market's shortcomings.

"We believe there are compelling reasons for international investors to view this market more favorably, particularly over the longer run," Yeo said, pointing out that China's economy is still growing a lot faster than many developed countries and that the Chinese government is trying to steer it away from its reliance on debt-fueled growth.

"We see the brightest earnings prospects among consumer-oriented stocks in line to benefit from the nation's structural growth," he said. "After all, China's middle class is growing fast, with 380 million millennials earning and spending more than their parents ever did on luxury items, travel and health care."

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