• International investment inflows to mainland Chinese stocks have increased since the fourth quarter, according to EPFR Global.
• The positive turn on sentiment comes as investment banks upgrade Chinese stocks.
• However, the data shows global emerging markets funds have increased their allocations more to India than mainland China, amid uncertainty about regulation and economic growth.

BEIJING — International investors are putting more money into Chinese stocks, even as local investors have remained cautious on the mainland markets.

Mainland Chinese stock funds saw net inflows of $16.6 billion in January — only the fourth time since the pandemic that monthly inflows have exceeded $10 billion, according to research firm EPFR Global. That followed nearly $11 billion in net inflows in December, the data showed.

"Investor interest in China has actually strengthened coming into the fourth quarter of last year," Cameron Brandt, director of research at EPFR, said in a phone interview last week. "The driver there I think is a perception — especially among institutional investors — that in the emerging markets space, China is, for a variety of reasons, something of a safe play this year."

The latest wave of buying is from institutions, rather than retail investors whose interest in China dropped off since early last year, Brandt said.

The divergent interest comes as global investment firms have turned increasingly positive on mainland Chinese stocks in the last several months.

Analysts are betting, in part, that Beijing wants to ensure growth in a year the ruling Chinese Communist Party is set to choose its next leaders at a national congress in the fall. At the same meeting, President Xi Jinping is expected to take on an unprecedented third term in power.

"Everything will need to look quite to perfection for [such] a monumental event," Jason Hsu, chairman and CIO of Rayliant Global Advisors, said in a phone interview last week. "For anyone who is a rational investor, this is probably as favorable a sentiment as you're going to get."

China has also become "a good contrarian play" this year because the local market is entering a period of stimulus and easier policy, while the U.S. Federal Reserve embarks on a tightening cycle, Hsu said.

Goldman Sachs and Bernstein are so optimistic that they each released lengthy reports in the last few weeks recommending mainland Chinese stocks, also known as A-shares.

The upbeat calls come despite worries about how regulatory uncertainty may have made those stocks "uninvestable."

"We believe China A shares, a US$14tn asset class, have become more investable given the ongoing liberalization and reform measures in the Chinese capital markets," Goldman's chief China Equity Strategist Kinger Lau and his team said in an 89-page report Sunday.

In the last 18 months, Beijing has cracked down on alleged monopolistic practices by Chinese internet companies and property developers' high reliance on debt, among other issues. The sometimes abrupt policy changes have surprised global investors.

Global emerging markets funds have turned to India in the meantime, EPFR data showed.

"Managers of funds who run diversified funds, they're less enthusiastic about China, certainly relative to other markets," Brandt said.

Average allocation to China has fallen from 35% of the portfolio in the third quarter of 2020 to 27% as of Jan. 1, according to Brandt. During the same period, he said the funds' allocation to India rose from 8.5% to 12.7%.

Market pessimism in China

Although the mainland Chinese stock market is the second largest in the world by value, it differs significantly from that of the U.S., the world's largest.

Speculative retail investors rather than institutions dominate the mainland market, which for years has drawn comparisons to a casino.

But there have been signs of progress.

In a sign of how the market is maturing, index giant MSCI decided in 2018 to add some China A-shares to the benchmark MSCI Emerging Markets Index. The move forced international funds tracking the index to buy more A-shares. But retail investors still dominate the mainland market by far.

Weak onshore sentiment, along with better opportunities in developed markets, have contributed to J.P. Morgan Asset Management's neutral view on Chinese stocks since early last year, Sylvia Sheng, global multi-asset strategist at the firm, said in a phone interview Monday.

She said if growth improves in the second quarter, sentiment could turn as well, noting: "We are actually looking to get more positive on Chinese equities."

The Shanghai composite is up about 3% for February to-date after a week-long closure for the Lunar New Year holiday. The index had kicked off the year with a decline of 7.65% in January — its worst month since October 2018. Last year, the index posted relatively muted gains of 4.8%.

Everyone's sentiment on investing in A-shares has dropped significantly, Schelling Xie, senior analyst at Stansberry China, said in a phone interview Friday. He pointed to uncertainty about the degree of change on regulation and economic growth.

Although some economists have said the worst of China's regulatory crackdown is over, they also said it doesn't mean a reversal or an end to new rules.

It will take time for the market to rebuild confidence, but it is not appropriate to be overly pessimistic right now, Xuan Wei, chief strategist of China Asset Management, said in a note. He added that there are opportunities in new energy and technological growth stocks.

China opening to foreign finance

While analysts assess Chinese stock performance, the mainland market increasingly offers business opportunities for international investment firms.

The financial industry is one of the few areas in which Beijing has relaxed ownership restrictions in the last few years. The policy changes have allowed BlackRock, Goldman Sachs and UBS among others to buy full control of their local securities or mutual fund operations.

"One of the reasons why we're bullish is we work in an area where China has really opened up in a big, big way," said Brendan Ahern, chief investment officer of KraneShares. The firm sells one of the primary U.S.-listed exchange-traded funds that tracks Chinese internet stocks, KWEB.

"In general, I think there's this disparity between what the Chinese think about China and what foreign investors think about China," Ahern said.

KWEB is up 3.8% for the year so far after dropping by more than 50% in 2021. Hong Kong's Hang Seng index is up about 5.5% year-to-date, while the Shanghai composite is down about 4.7%.

Overseas investors generally "like to buy China for growth" rather than banks and other industries with many state-owned enterprises, said Winnie Wu, China equity strategist, Bank of America Securities.

However, she noted the state-owned businesses have led recent outperformers, a trend she doubts can lead to sustained gains for the market.

"Our overall view is this year, [the] China market is not an easy bull market," she said. "It's more likely to be buying on hope and selling on fact and results."