So far in 2019, Chinese stocks have led global markets higher. Cheap valuations and renewed easing from major central banks, including the People's Bank of China (PBOC), are the notable drivers behind the rally. Rising stock markets have a tendency to create a spillover wealth effect. When equities rise, cautious savings behavior wanes and is replaced by consumption and optimism for the future. When stocks fall, the opposite takes place.

As Beijing grumbles about continued weak economic data, the rising stock market is an ideal first step. Should the wealth effect kick in, this may spur a recovery in retail sales and investment spending – both of which remain weak.

Domestic retail investors still drive markets

So the exuberance for the market should continue as foreigners are expected to increase their weighting to Chinese domestic equities following MSCI's decision to increase exposure into the world's second-largest economy for its global and emerging market indices. Preliminary estimates say the new adjustments could attract between US$80-100 billion into the country's A-shares.

For Beijing, MSCI's decision is a victory for China's US$6.9 trillion domestic stock market. Significant foreign institutional investors coming into China injects credibility, particularly when several Chinese technology giants have chosen to list in the US as American depositary receipts (ADRs) in recent years. China also hopes that foreign money will increase not only competition but will push companies' corporate governance to match international standards.

While foreign institutions should expect a red carpet welcome, they shouldn't expect a walk in the park. China's equity markets are highly volatile due to the make-up of its investors, where 148 million retail investors account for 80% of trading activity.

At US$100 billion of potential inflows, foreign institutional money will remain dwarfed by local punters. Retail investors trade on transient news flow momentum, and this counters the traditional practice of foreign institutions that focuses on long-term investment horizons.

Lurking market dangers

Markets bulls argue that since retail investors are more volatile, their behavior is decoupled from global flows – thus increasing Chinese equity exposure is an indirect hedge which helps diversify portfolio risks. But this optimistic spin is misplaced, as it counters Beijing's efforts to produce a more efficient market for raising capital.

Investors would then need to ask: who is leading whom? Following the local fund flows would ignore commonly used valuations metrics, like price-to-earnings (PE) multiples, which means foreign investors would purchase expensive (relatively higher PE multiple) stocks.

Over the longer term, investors need to think hard about whether more efficient and productive companies can attract capital flows. This challenge comes at a time Beijing is also focusing on channeling more bank loans to small medium enterprises and private companies. Chinese equity markets do not provide substantial liquidity to compete with banks, but expectations that foreigners will eventually enter China may prevent Beijing from taking real policy initiatives to reform its financial institutions.

For investors, it's also worth remembering that many Chinese stocks are listed in Hong Kong – an international stock market with a much larger institutional presence. This can often mean that China-based, listed companies there trade at much more reasonable (and realistic) valuations which naturally lends itself to a long-term perspective when investing.