Last updated: 21:33 / Wednesday, 31 August 2016
Column by PineBridge

The Wait Is Over: The Shenzhen-Hong Kong Stock Connect

The Wait Is Over: The Shenzhen-Hong Kong Stock Connect

The Shenzhen-Hong Kong Stock Connect was approved in principle on Monday by the China Securities Regulatory Commission and Hong Kong’s Securities and Futures Commission. Global markets have been widely anticipating the Connect because it will allow global investors to trade stocks listed on the two exchanges. In an unexpected move, aggregate quotas for both Shanghai and Shenzhen Connect schemes also were abolished, although daily quotas remain.

Eligible shares will include Shenzhen Stock Exchange (SZSE) Component Index, SZSE Small/Mid Cap Innovation Index (which has a market cap of more than RMB6 billion/ US$900 million), Hang Seng Composite Large-Cap/Mid-Cap and Small-Cap index (over HK$5 billion/US$600 million market cap), and Shenzhen/Hong Kong dual-listed stocks. About 880 Shenzhen stocks and 417 Hong Kong stocks are qualified under Shenzhen- Hong Kong Stock Connect. Implementation should begin by late in fourth-quarter 2016.

Why the anticipation?

The Shenzhen-Hong Kong Connect represents another critical step in China’s capital market reforms. We believe it will further boost the case for the inclusion of A shares in MSCI indices, which could attract large amounts of fund flows to the Chinese stock market. (Although concerns over capital mobility, share suspensions, and restricted availability of A-share products are still being addressed.)

Through the Shenzhen-Hong Kong Connect, the Shenzhen exchange also will provide global investors with more opportunities to gain access to China’s new economy, particularly in sectors such as IT, high-end manufacturing, and new materials. The Shanghai exchange, in contrast, is dominated by state-owned banks and oil companies.

Finally, mainland China investors will also be able to diversify their exposure into the Hong Kong market. Our recent conversations with brokers, however, suggest that many of the mainland investors with a keen interest in Hong Kong are already invested, either through Shanghai-Hong Kong Stock Connect or through a local brokerage account in Hong Kong. It will be interesting to monitor the size of Southbound flows into Hong Kong Small/Mid-Cap names, to see whether or not the A-H share gap will finally narrow.

What next?

At first glance, banks and brokers should benefit initially from the potentially increased trading flows following the implementation of Shenzhen-Hong Kong Connect. However, we expect the incremental trading volume and, thus, revenue impact from Shenzhen-Hong Kong Connect to be minimal in the near term. Apart from the short-lived rally in April 2015, flows from Shanghai-Hong Kong Stock Connect have largely been disappointing, though they have picked up recently.

Although high valuations of many Shenzhen-traded companies – with an average of 40x price/earnings ratio compared with around 16x in the Shanghai Composite Index and 12x in MSCI China Index – may deter initial interest, the strong earnings growth for many Shenzhen-traded companies certainly warrants a closer look from investors.

What about H-shares?

Following Brexit, the MSCI China index rallied by more than 15%, driven by improving global sentiment and speculation on Shenzhen-Hong Kong Connect. Although MSCI China index looks cheap compared to it’s A-share peers, it is currently trading at close to its five-year high in P/E terms, while firsthalf earnings thus far point to softening fundamentals. Meanwhile, recent macro data released showed weakening momentum as recent stimulus measures fade. With Shenzhen-Hong Kong Connect, brokers and asset managers and their investors should be the biggest beneficiaries in the long term, though the potential risk/reward return has been reduced after the recent rally.

Wilfred Son Keng Po is Managing Director and Portfolio Manager of Asia ex-Japan Equities at PineBridge Investments.

This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.