Over the past 20 days, Kweichow Moutai, China Merchants Bank, and Ping An Insurance have been the most net-purchased A-share stocks by Northbound capital. The net purchases of these three stocks reached 8.134 billion yuan, 2.361 billion yuan, and 2.285 billion yuan, respectively.

After a hiatus of six months, Northbound capital, which reflects the movements of foreign capital, has returned to the Chinese stock market.

Data from Wind (Wangdian) shows that in February, Northbound capital cumulatively increased its holdings in the A-share market by 60.744 billion yuan, setting a 13-month high. Among this, the net purchase for the Shanghai market was 45.158 billion yuan, and for the Shenzhen market, it was 15.586 billion yuan. In February, the net purchase volume of Northbound capital for A-shares has already exceeded the total for the entire year of 2023.

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Over the past 20 days, Kweichow Moutai, China Merchants Bank, and Ping An Insurance have been the most net-purchased A-share stocks by Northbound capital. Among the top 20 net-purchased stocks, financial stocks account for half. New energy stock CATL and liquor stock Wuliangye are also favored by foreign capital.

Although foreign holdings account for less than 4% of the total market value of A-shares, their actions often reflect the expectations of overseas capital for the Chinese market and are also known as "smart money." Therefore, the movements of foreign capital often influence the risk appetite of the A-share market. Behind the return of foreign capital to the Chinese stock market, in February, the CSI 300 index of A-shares rose by more than 9%, marking the best monthly performance since November 2022.

The bond market situation echoes this. As of the end of January, overseas institutions have increased their holdings of Chinese bonds for five consecutive months.

Driven by favorable factors such as Northbound capital, the foreign exchange market is also gradually warming up. As of the close on February 29, the spot exchange rate of the Chinese yuan against the US dollar rose to a one-week high, with the onshore yuan closing at 7.193. However, on March 1, the Chinese yuan's exchange rate against the US dollar closed lower, at 7.1985.

On February 29, Morgan Stanley released a research report stating that changes in regulatory policy stance, support for the private sector, stabilization of the real estate market, and a rebound in the price index are all contributing to the recovery of the A-share market and attracting capital inflows. In the future, whether China's economy and stock market will continue to warm up depends on whether macroeconomic policies will lead to price stability and promote consumption.

On March 1, Northbound capital net sold 5.333 billion yuan. By the close, the Shanghai Composite Index closed at 3,027.02 points, up 0.39%; the Shenzhen Component Index closed at 9,434.75 points, up 1.12%; and the ChiNext Index closed at 1,824.03 points, up 0.94%.Northbound capital inflow in February, data source: Wind

Foreign capital favors banks and liquor stocks

UBS has stated that northbound capital is the only institutional capital flow data in the A-share market that is published daily or even in real-time. As a rare high-frequency data, the trend of northbound capital always disturbs market sentiment.

Currently, the inflow of foreign capital into the A-share market is different from the situation in 2023. In 2023, the cumulative net inflow of northbound capital was 43.704 billion yuan. This is not only about half of the total amount in 2022 but also far from the initial forecast of 300 billion yuan by most institutions.

Looking at the industries where northbound capital holds shares, in February, the market value of northbound capital's increased holdings in the food and beverage and banking industries both exceeded ten billion yuan. In addition, non-bank financials, power equipment, automobiles, and electronics industries are also favored.

In terms of individual stocks, over the past 20 days, Kweichow Moutai, China Merchants Bank, and Ping An Insurance have been the A-share stocks with the most net purchases by northbound capital. The net purchases of these three stocks reached 8.134 billion yuan, 2.361 billion yuan, and 2.285 billion yuan, respectively.

Over the past 20 days, among the top 20 net purchase stocks, financial stocks account for half. They are China Merchants Bank, Ping An Insurance, Industrial Bank, ICBC, Jiangsu Bank, CITIC Securities, Bank of Communications, and Agricultural Bank. In other industries, new energy stock CATL and liquor stock Wuliangye also received large purchases.

Regarding institutional holding data, among the top ten holding institutions of northbound capital, six institutions have their largest holdings in Kweichow Moutai, and two institutions have their largest holdings in Midea Group.For buyers, according to calculations by the quantitative research team at UBS Securities, the market value of shares held by a certain Chinese securities broker in the Northbound Trading has recently increased significantly, reaching about 90 billion yuan in mid-February. At the end of 2023, this value was only about 20 billion yuan, and the industry distribution of its holdings is close to that of the CSI 300 Index.

However, a report from Founder Securities shows that as of January 23, the proportion of Chinese custodian institutions in the Northbound capital to the number of foreign banks and foreign securities firms' custodian institutions is about 30% to 70%. This means that the scale of Chinese custodian institutions is smaller than that of foreign institutions.

Policy support boosts foreign capital sentiment

Morgan Stanley believes that changes in regulatory policy positions, support for the private sector, stabilization of the real estate market, and a rebound in price indices are all contributing to the recovery of the A-share market and attracting capital inflows.

In terms of policies to boost the stock market, on the one hand, to avoid the spread of pessimistic sentiment, China's "national team" funds have entered the market to support it. According to UBS calculations, so far this year, the "national team" may have inflow into A-shares through ETFs (Exchange Traded Funds) exceeding 410 billion yuan, and it is expected that in extreme market conditions, the "national team" holdings may continue to rise.

On the other hand, regulatory measures targeting quantitative funds are continuous. Recently, investment departments represented by quantitative funds with over a trillion yuan have been asked to reduce leverage to reduce systemic impact on the Chinese stock market. Some analysts argue that the convergence of quantitative high-frequency strategies can easily lead to the convergence of programmatic buying and selling signals from different private fund managers, thereby forming a feedback loop of rising and falling together.

At the same time, the Chinese government's support for the real economy is also strengthening. On February 20, the 5-year Loan Prime Rate (LPR) for loans was lowered by 25 basis points, the largest cut in history. The benchmark lower limit for China's national mortgage loan interest rate policy will be adjusted to 3.75%, a historical low. The financial support for real estate developers is also increasing.

The market has responded strongly. Data compiled by Bloomberg shows that on February 20, Chinese dollar junk bonds, mainly from real estate developers, recorded the largest single-day increase in nearly a month. As early as November 2023, the offshore credit market pressure, mainly from real estate dollar bonds, has also eased, with the pressure level dropping from level 3 to level 1.

For foreign capital, another consideration that attracts them to return to the A-share market is that A-shares are undervalued, and they are mostly under-allocated, which means there is room for adjustment.

"We (on A-shares) have reached an oversold state, and the policy response is much stronger. Therefore, I expect the market to have more tactical upside from the current level," said Arthur Budaghyan, Chief Emerging Markets Strategist at BCA Research."Many investors are underweight in China, and they need to reconsider their position allocation as soon as possible," said Karine Hirn, a partner at East Capital Asset Management.

As of the end of February, the forward price-to-earnings ratio of the MSCI China Index was 8.9 times, lower than the 5-year average of 11.9 times, and also below the level of emerging market peers, which is above 12 times. According to data from the fund flow monitoring platform EPFR, the current global mutual funds' net allocation rate to Chinese stocks is 6.8%, the lowest level in the past 5 years. By the end of December 2023, the figure was 5.5%, the lowest level in the past 10 years.

Fundamentals and China-U.S. Interest Rate Differential

The return of foreign capital to the Chinese stock market echoes the bond market trends. Data from the Central Depository & Clearing Co., Ltd. and the Shanghai Clearing House show that by the end of January, overseas institutions held 3.87 trillion yuan of domestic RMB bonds, an increase of 202.8 billion yuan month-on-month. This marks the fifth consecutive month since September 2023 that overseas institutions have increased their holdings of RMB bonds.

The foreign exchange market also shows a warming trend. As of the close on February 29, the spot exchange rate of the RMB against the U.S. dollar rose to a one-week high, with the onshore RMB closing at 7.193. On March 1, the RMB exchange rate against the U.S. dollar closed lower, at 7.1985.

Xing Zhaopeng, a senior China strategist at ANZ, believes that northbound capital can play a role in stabilizing the RMB exchange rate. In the first half of 2024, it is expected that the RMB will have some appreciation space against non-U.S. currencies. However, against the backdrop of the continuous strengthening of the U.S. dollar, the RMB exchange rate against the U.S. dollar is difficult to rebound.

In the capital account of the balance of payments, in addition to securities investment, foreign direct investment (FDI) in China is another major channel for foreign capital inflow into the Chinese market. In Xing Zhaopeng's view, the main return of foreign capital is still arbitrage capital, while FDI belongs to the basic balance of payments under the capital account, and the return of foreign capital in the stock and bond sectors may not be able to offset the net outflow of FDI.

BNP Paribas believes that factors such as the China-U.S. interest rate differential, export cycle, seasonal factors, the People's Bank of China's foreign exchange policy, and structural changes in capital outflows and inflows will affect the trend of the RMB exchange rate. The bank's report released in mid-January believes that the RMB exchange rate against the U.S. dollar is expected to fluctuate between 7.1 and 7.3.

As for whether northbound capital will continue to flow back in the future, Bao Xiadong, the emerging market investment manager at Edmond De Rothschild Asset Management, believes that it still depends on the fundamentals of China's economy.

"Whether China's macroeconomic data can continue to improve sustainably, whether price levels can stabilize, whether the profit expectations of listed companies, especially the private sector, will be revised upwards, and whether China-U.S. relations will stabilize. These are the factors we are concerned about," he said.Xiong Yi, Chief Economist for China at Deutsche Bank Group, believes that fiscal policy will be the key to China's economic growth in 2024. It is anticipated that the Chinese government will introduce a new round of fiscal stimulus in the form of a one-off issuance of special government bonds, with an estimated total scale of around 1 trillion yuan. In addition, stimulating consumption remains crucial for economic development, and China is encouraging consumers to exchange old goods for new ones, with plans to provide a certain scale of fiscal subsidies.

Apart from the fundamental factors of China's economy, BNP Paribas also believes that the narrowing of the China-U.S. interest rate differential will encourage inflows of foreign capital, thereby boosting the value of the Chinese yuan.

However, against the backdrop of the U.S. inflation slowdown being obstructed and the labor market stabilizing, expectations for the Federal Reserve to cut interest rates in March and May are gradually being shattered. This implies that U.S. Treasury yields will remain high, and the China-U.S. interest rate differential may come under pressure.

As of now, institutions such as the World Bank, Goldman Sachs, Morgan Stanley, and UBS have all indicated that the Federal Reserve will not cut interest rates until at least June. Most of these institutions believe that in 2024, the Federal Reserve will cut interest rates three to four times. On March 1st, the spread between the 10-year government bond yields of China and the U.S. exceeded 180 basis points.