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The long-awaited Shenzhen-Hong Kong Stock Connect (SZ Connect) will be launched on 5 December where a two-way trading link between the two exchanges will be established. More stocks will be available for trading for investors in the 2 cities. For Northbound investors, there will be 881 Shenzhen-listed stocks. For Southbound investors, 417 stocks will be eligible for investors to trade on.

We share three thoughts on the SZ Connect:

  • A tale of two exchanges: Shenzhen vs Shanghai
  • History may not repeat itself
  • Bond Connect could be next
  1. A tale of two exchanges: Shenzhen vs Shanghai

The Shenzhen Exchange is the marketplace for smaller listed growth companies. Shenzhen listings is the embodiment of ‘New China’ as they are more concentrated in emerging sectors such as Technology, Healthcare and Media. They include names such as cinema operator Wanda Cinema Line and video surveillance market leader Hikvision.

On the other hand, Shanghai listings are skewed towards ‘Old China’ with representations in the Financials and Energy sectors. They include giant state-owned enterprises (SOEs) such as ICBC, Ping An and Petrochina. In terms of market cap, 74% of Shanghai companies are SOE-linked compared to 26% for Shenzhen companies.

In terms of valuation, Shanghai companies are trading at cheaper valuation compared to its Shenzhen peers. The Shanghai Composite Index is trading at 13.7x FY17 P/E, where else the Shenzhen Composite Index is trading at 24.7x FY17 P/E. This could be explained by the better growth prospects of Shenzhen companies. Both are trading at 1 standard deviation above its 3-year historical mean.

P/E chart of Shanghai Composite Index

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Source: Bloomberg

P/E chart of Shenzhen Composite Index

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Source: Bloomberg

 

  1. History may not repeat itself

Shanghai Stock Connect (SH Connect) was launched on 17 November 2014 and there was a strong rally of 30% in both A- and H-shares three months after the official launch of the SH Connect. A large part of the rally could be explained by PBOC’s interest rate cuts and the explosion of margin financing. This time, we expect response to the SZ Connect to be more muted as the recent weakness of the Chinese Yuan will deter foreign investor into Chinese equities.

After the initial euphoria, the domestic Chinese equities also seemed to have lost its lustre. The Chinese equities have corrected significantly with de-rating for the Chinese banks. In fact, the share price discrepancy between shares listed in Shanghai and Hong Kong has widened. Average A-share premiums have widened from 30% to 89% since the inception of Shanghai Stock Connect. Thus, it is unlikely that SZ Connect will help in narrowing of the premiums.

One-year chart of Shanghai Composite Index

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Source: Bloomberg

One-year chart of Shenzhen Composite Index

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Source: Bloomberg

 

  1. Bond Connect could be next

Looking forward, the next capital market connection could be in the form of a bond Connect. The Financial Services Development Council (FSDC) has proposed a linkage between Hong Kong and mainland bond markets for retail investors. China’s bond market is estimated to be in excess of US$8.5 trillion in contrast to the US$400 billion size of Hong Kong’s bond market. The size of the bond market is significantly larger than the equities market. Thus, the Bond Connect will be a step in the right direction for improving the investment landscape in China.

With these Connects coming into place, the capital markets in China will be further liberalized. This will strengthen the case for foreign investors to take a deeper look into China and consider investment in China’s “A” shares as part of their core portfolios.

 

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