China has weighed on the performance of emerging markets over the past two years, and while the relaxation of Covid restrictions in November 2022 initially spurred a three-month rally in Chinese equities, those gains have since been erased. The hottest topic in town is now whether the country’s sputtering growth and property market troubles could lead to its “Japanification”.
Nonetheless, emerging market fund managers have largely kept faith with China, not least because the world’s second-largest economy is too substantial to ignore. At 30% of the MSCI Emerging Markets index, it is more than twice the size of the next largest allocation, Taiwan. If an emerging market fund manager were to shun China, that allocation would be a glaring departure from the benchmark.
Some emerging market fund managers took overweight positions to China in the early optimistic days of the re-opening but on average they are now back to holding around 30% in the country, reflecting the benchmark.
“Managers still allocate heartily to China,” says Alex Watts, investment analyst, at interactive investor. “China offers undeniable potential in its capacity as a producer and consumer of innovative goods and as one of the most populus countries on the planet. However, there are risks that may deter investors, such as concerns regarding domestic and foreign policy, corporate governance and the domestic property market.”
China’s slump is harming emerging market fund performance
Recently, investing in China has been a bumpy ride. Watts points out, at the time of writing in early September, that over the past six months the MSCI China index has fallen over 10% in sterling terms versus a 3.4% gain for MSCI Emerging Market ex China.
In addition, Watts notes that valuations of Chinese stocks have fallen over the past two years, trading at lower multiples to other emerging market and developed market countries.
He adds: “Consequently a passive China allocation will have demonstrated substantially elevated volatility versus other emerging market regions.”
However, the will of the Chinese authorities to ensure economic success should not be underestimated, and neither should the will of the Biden administration to maintain a relationship with its economically important adversary.
James Budden, director of marketing and distribution at Baillie Gifford, says: “Making their countrymen wealthier and happier is at the heart of the politburo’s licence to govern, and they have been successful at it and have the firepower to put to use in terms of stimulus and support, so they are well positioned to manage a downturn.”
China’s government making moves to restore confidence
At the beginning of September, the People’s Bank of China stepped up its support of the renminbi by cutting the reserve requirement ratio for foreign exchange deposits.
At the same time, cuts were made to mortgage interest rates and downpayment ratios in some major cities to restore confidence in the housing market, which had been further shattered when housing companies such as Zhongrong Trust defaulted on payments to corporate investors in August.
In the same month Biden signed an executive order to restrict US investment in Chinese technologies, but pulled his punches, limiting the new measures to only three areas: semiconductors, quantum information technologies, and artificial intelligence, aware that further restrictions would impose huge legal costs on businesses and hinder expansion of existing operations in China.
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The consensus is that there is political will to resolve these issues despite the posturing of both sides, and certainly some fund managers believe the situation will resolve and are keen to take advantage of current low valuations.
“It’s hard to believe that the MSCI China Index is almost back to its 2022 lows, a period when more than 400 million people were under lockdown measures and US trade tariffs were beginning to bite,” says Nick Payne, investment manager, global emerging markets at Jupiter.
He adds: “The populace were subject to a very different Covid-19 experience to the West, and a draining, long-haul-slog of a lockdown has understandably made citizens weary and wary of a false dawn. As a nation of savers who were not given helicopter money by their government, those savings are hard-earned and will take time to be released.”
However, Payne notes we have begun to see increasing confidence, with the government recently announcing a number of stimulus measures, which are a step in the right direction.
Payne says: “Improving consumption has been stated as a core government goal, looking to print 5% GDP growth this year.”
“This backdrop means we are able to find compelling investments. Kweichow Moutai, listed on the onshore China A share market, is a good example. Moutai is China’s leading producer of the nation’s fiery spirit Baiju, with its principal brand Feitian Moutai (“flying fairy”) commanding over $400 per bottle.”
He adds that Moutai is made in limited quantities and as a potent symbol of success in China, demand far exceeds supply.
“Indeed, similar to luxury watches, prices in the secondary market for Moutai can be multiples higher than the recommended retail price,” says Payne.
A giant Moutai liquor bottle at a scenic spot in Renhuai City in China's Guizhou province. Credit: CFOTO/Future Publishing via Getty Images.
Chinese shares the pros are drawn to
There are indeed great companies in China, particularly in renewables such as solar and batteries. Budden cites CATL, a lithium-ion battery maker; Longi, a photovoltaics company and solar power developer; NIO Inc ADR (NYSE:NIO), a provider of electric vehicles; Zhejiang Dayuan Pumps, which makes pumps and presses; TikTok owner ByteDance; and sportswear company Li Ning Co Ltd (SEHK:2331).
Charles Bond, emerging market fund manager at Invesco, points out that now is a good time to be sizing up China, due to declining valuations. He says that “valuation levels suggest a degree of capitulation by the market, which we see as an invitation to capture opportunities, taking a three to five-year view”.
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Bond says he leans into areas unloved by the market and, as such, the Invesco Global Emerging Markets fund is overweight (holds more than the index) in Hong Kong and China.
“In particular, we are overweight China consumer discretionary stocks, as consumer demand remains resilient despite concerns in the property sector, where we are underweight. For example, the fund recently entered a position in Yili, China’s largest dairy company by revenue, where the share price has fallen relative to earnings.
“Around half our Chinese exposure is in the internet sector. They as a group are showing earnings growth despite the poor macro background. This is a good example of how stock specifics can trump macro considerations. In this case, the turn to a more favourable regulatory environment for the sector is proving more important than macro challenges.”
Move towards indirectly investing in China
That is not to say that some investment managers haven’t turned away from China.
“Capital moving away from China has been a theme for four to five years owing to the US trade war,” says Andy Ho, chief investment officer of VinaCapital Group.
“The global Prudential team sit in Hong Kong, for example, so it is possible to invest in a UK company taking advantage of China’s potential, with all the corporate governance and transparency that implies,” says Ho.
Similarly, for example, Nike (NYSE:NKE), Estee Lauder (NYSE:EL), and LVMH (EURONEXT:MC) derive significant proportions of their revenue from China, with opportunities for long-term growth in the region.
In an echo of Japan’s dominance of the Asian indices in the 1980s-1990s, investors are beginning to separate out their China exposure from their other emerging market holdings, with 14 asset managers launching Emerging Markets excluding China funds so far this year. That still leaves a large universe of more than 16,000 companies listed on emerging markets, providing plenty of choice.
However, active management is sensible when investing in emerging markets as more than 80% of companies listed in emerging markets fail to beat their cost of capital, thus destroying shareholder value, says Payne.
Furthermore, “selecting an ex-China strategy may not totally protect you against goings-on in the Chinese markets, as there is still a level of correlation and revenue exposure to China in other regions”, says Watts.
He picks out interactive investor’s ACE 40-listed Stewart Investors Global Emerging Markets Sustainability Fund, managed by Sujaya Desai and Jack Nelson. The fund managers use a bottom-up approach to create a benchmark differentiated portfolio. While the fund does allocate to China, the position is dramatically underweight, at less than 10%, preferring instead India, which currently accounts for 40% of the portfolio.
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