Why emerging markets will weather China’s regulatory crackdown just fine
- Most emerging-market investors have little choice but to stick with China as its size and importance force investors to maintain their exposure
- With previous China-led sell-offs having given way to rallies, emerging-market stocks could recover sooner than many think
Are Chinese stocks uninvestable? That the question is being asked is an indication of the extent to which global investors have been taken aback by the ferocity of Beijing’s regulatory crackdown on sectors ranging from education to technology.
In a report published last week, investment strategists at Goldman Sachs said the word “uninvestable” featured in many of their conversations with clients regarding the outlook for Chinese equities.
In a report published on July 30, US investment adviser Evergreen Gavekal said the share prices of Chinese education firms make for “some of the most traumatic viewing” since the 2008 global financial crisis and “reflects a landscape upended by government action”.
While the escalation in political and regulatory risk in China has weighed on sentiment across asset classes, emerging markets are the most vulnerable to financial contagion. In 2005, China’s weighting in the MSCI Emerging Markets Index – a leading gauge of stocks in developing economies – was only 7.6 per cent. Today, China accounts for 37.5 per cent of the index.
The world’s second-largest economy also dominates JPMorgan’s Corporate Emerging Markets Bond Index, which tracks the performance of dollar-denominated corporate debt in developing countries. China constitutes 26.3 per cent of the index – Hong Kong makes up a further 6.7 per cent – and is expected to account for nearly 43 per cent of the gross issuance of emerging market corporate debt this year, according to JPMorgan data.
Developing nations’ stocks have lost a further 5.5 per cent since June 28 and are barely in positive territory for the year. By contrast, the MSCI World Index, a gauge of stocks in developed markets, is up 15 per cent this year.
China’s growing presence in emerging market stock and bond indices is now seen as a vulnerability, particularly for popular passive investment vehicles that track the performance of an index rather than attempting to outperform it.
This time, the spillover effects are less severe. One of the most notable aspects of China’s regulatory clampdown is the lack of contagion, particularly in debt markets. While emerging market corporate bond spreads surged towards the end of 2015, they rose only modestly last week.
Furthermore, there are already signs that the steep declines in Chinese stocks are encouraging investors to buy the dip. Chinese equities are enjoying their longest stretch of net purchases by foreign investors via trading links with Shanghai and Shenzhen since late April, according to Bloomberg data, driven by cheap valuations relative to US shares.
Nicholas Spiro is a partner at Lauressa Advisory