Plans for a new Shanghai-Hong Kong trading system are among three developments that we expect will give a boost to China's equity markets in the medium to long term. So despite concern about the economic outlook, now could be the time to begin rethinking China from an investment perspective.

Valuations Are Low

For many investors, the performance of China's equity markets since 2007 has been frankly disappointing, and well below that of stock markets in both emerging and developed countries. While China's high total debt, slowing economy and complex policy agenda suggest that a sharp turnaround in its equity markets is unlikely to occur very soon, we believe that conditions for improved performance are already falling into place.

Three things are happening: first, domestic equity valuations have bottomed out, to the extent that China's equity markets are now the cheapest in Asia ex-Japan (Display); second, the government is continuing to implement selective stimulus measures to cushion the economy against a hard landing (and to provide breathing space to introduce financial and economic reforms which, in themselves, will be positive for China's capital markets); and third, financial market liquidity is growing.

Liquidity Is Improving

Growth in liquidity is of particular interest at the moment. A new avenue for share trading between China and the rest of the world is expected soon, with the launch of Shanghai-Hong Kong Stock Connect, a system which will enable share trading to take place between the Shanghai and Hong Kong stock exchanges. The initiative-which is nearly operationally ready and awaiting its final launch date-is the latest in a series of moves designed to increase foreign access to China's capital markets. It may have the potential to cause an investor re-rating of the country.

China has already improved foreign investor access to its capital markets. The introduction of the Qualified Foreign Investment Institution (QFII) in 2003 has allowed foreign investors to trade domestic-currency "A" shares on the Shanghai and Shenzhen stock exchanges, and bonds on the listed and interbank markets. And since 2011, the Renminbi Qualified Foreign Investment Institution (RQFII) has allowed financial institutions in Hong Kong-and, increasingly, other cities-to launch RMB-denominated funds for investment in mainland China.

Boost to Foreign Investor Quotas

Stock Connect will provide another channel for foreign funds. It will allow offshore investors to buy directly "A" shares listed in Shanghai, while also easing the restrictions on Chinese investors' ability to buy Hong Kong-listed stocks and providing a significant boost to the foreign investor quotas already available (Display). This should lead to three important developments: the opportunity to invest in non-dual-listed "A" shares-the stocks of leading Chinese companies previously not available to foreign investors; the scope for investors to arbitrage price differences in stocks listed on both exchanges (something not easily done previously), and greater investment flows, which should be supportive for valuations.

It may also smooth the way for "A" shares' inclusion in the MSCI Emerging Markets Index-something that was actively considered earlier this year, before Stock Connect was announced. The index provider shelved the idea after it took into account feedback from investors about liquidity constraints they face when investing under the QFII and RQFII programs. MSCI has said that it will reconsider the move next year. The difference then will be that Stock Connect should be up and running.

Although it's not clear whether Stock Connect will definitely trigger the inclusion of China "A" shares in the index (it will impose quotas on the volume of stocks that can be bought and sold, for example, and impose a ban on day trading), we believe that it's highly likely that China will take a step further down that road.

For investors who have been able safely to ignore China for the last few years, this should be food for thought: the inclusion of "A" Shares in the index would force those who follow the index to increase their allocations to China. This alone would be sufficient, in our view, to stimulate significant foreign inflows into the country's equity markets.

http://seekingalpha.com/article/2650725-time-to-rethink-chinas-equity-markets