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Visitors at Yuyuan Garden in Shanghai, China, on December 23. An abrupt surge in foreign buying of Chinese bonds raised hopes that pessimism about the nation’s assets may be overdone. Photo: Bloomberg
Opinion
Macroscope
by Nicholas Spiro
Macroscope
by Nicholas Spiro

Why investors in emerging markets can’t easily abandon China

  • A growing number of investors in developing economies are carving China out of their portfolios, but they are merely trading one set of risks for another
  • Fund managers cannot ignore the influence China has over emerging markets, especially in Asia, and alternatives are not as cheap as they used to be
Nicholas Spiro
Nicholas Spiro
Why you can trust SCMP
Is there no let-up in the meltdown in China’s stock market? After losing a further 11 per cent last year, the CSI 300 index of Shanghai- and Shenzen-listed shares suffered its worst start to the year since 2019, dragged down by persistently weak economic data.

Since its peak in 2021, the CSI 300 has fallen more than 40 per cent. The decline in the MSCI China Index – which tracks Chinese stocks listed at home and abroad – has been even sharper, with the gauge falling nearly 60 per cent. Foreign purchases of Chinese shares via trading links with Hong Kong fell to their lowest level on record last year.

Still, the dramatic deterioration in sentiment towards the world’s second-largest economy did not prevent the MSCI World Index – a gauge of equities in advanced economies – from rising 22 per cent in 2023, mainly because of the 70 per cent weighting of the United States in the index. US technology giants, commonly referred to as the “Magnificent Seven”, turbocharged the rally in US and developed market stocks.

Yet, it is the performance of emerging-market equities that is more striking. The MSCI Emerging Markets ex China Index, which monitors stocks in developing economies other than China, surged 17 per cent last year despite mounting concerns about China’s economy.

What is more, the assets held by the largest exchange traded fund (ETF) tracking the emerging market ex-China index surpassed those held by the biggest China-focused ETF for the first time, having risen sharply in the final quarter of 2023. Three years ago, the China ETF was more than 50 times bigger than its emerging market ex-China counterpart, according to Bloomberg data.

The shift away from China in emerging-market investment portfolios has been gathering steam for some time. The combination of Beijing’s draconian zero-Covid policy, the weaker-than-expected recovery following the reopening of the economy and heightened regulatory and geopolitical risks led to a surge in demand for emerging-market investment products that exclude China, particularly Asia ex-China products.
There a sense among many foreign investors that China’s weighting in the benchmark emerging-market stock index is too large. Meanwhile, other leading developing economies hold more appeal and have proved resilient to the aggressive tightening of monetary policy in the United States.
According to data from JPMorgan, foreign purchases of Indian stocks reached US$20.5 billion last year while foreign buying of South Korean and Taiwanese equities stood at US$10.1 billion and US$6.5 billion, respectively. The three economies, moreover, have a combined weighting of 44 per cent in the emerging-market equity index. China’s weighting, by contrast, has fallen to 28 per cent.

This raises the question of whether the balance of power in the stock markets of developing economies is tilting from China to other emerging markets, especially within Asia. As a growing number of emerging-market investors carve China out of their portfolios, is it only a matter of time before “ex-China” becomes the dominant investment strategy in the developing world?

Not so fast. First, the rising popularity of the emerging market ex-China theme stems mostly from mounting pressure on investors to manage and mitigate their China risk. While the emerging market ex-China index offers scope for diversification, reducing China’s influence is easier said than done.

Emerging market successes show global economy not just doom and gloom

Comparisons with the split-off of Japan from the MSCI Asia Index in 2001 are misleading. Not only was Japan a major developed market that accounted for more than 70 per cent of the Asia gauge at the time of its removal, supply chains are now more globally interdependent, with China playing a crucial role in the semiconductor industry that powers the stock markets of Taiwan and South Korea. Given the combined 40 per cent weighting of both economies in the emerging market ex-China index, “ex-China” is something of a misnomer.

Second, no other equity market in the developing world has the breadth and depth of China. Even after its steep decline, the combined market capitalisation of the Shanghai and Shenzhen bourses was US$9.6 trillion as of late 2023, the second-largest in the world and more than double that of India.

Although India’s consumption-fuelled growth has helped deliver eight straight years of stock market gains, the country’s share of global consumption is stuck below 4 per cent, compared with China’s 14 per cent, HSBC notes.
A vendor waits for customers at a local market in Mumbai on December 18, 2023. The BSE Sensex stock index closed at 71,315.09 on December 18 after surpassing the 71,500-point mark for the first time. Photo: EPA-EFE

Furthermore, the emerging market ex-China index is more sensitive to global financial and economic conditions, particularly volatility in US monetary policy. Investors seeking ways to hedge against threats in China by betting on other emerging markets are exchanging one set of risks for another.

Even though developing nations proved more resilient to the US Federal Reserve’s aggressive tightening campaign than expected, emerging-market bond funds suffered the second-largest outflows last year since records began, according to JPMorgan data.

Third, as the emerging market ex-China strategy becomes more popular, valuations are becoming more expensive. In a report published in November last year, Goldman Sachs said “valuations no longer look as compelling”. It also said one of the conditions for a broad-based rally in emerging markets was a stronger recovery in China.

It is not surprising emerging-market investors are seeking alternatives to China. However, fund managers cannot easily abandon the world’s second-largest economy, mainly because of the influence it wields over emerging markets, especially in Asia. The “ex-China” trade, moreover, presents its own risks and is not as cheap as it used to be.

Nicholas Spiro is a partner at Lauressa Advisory

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