When Japan’s epic asset bubble burst in the early 1990s, fund managers faced a surge in demand for new investment products for Asian stock markets that excluded the region’s largest developed economy. Even by the end of the decade, Japan still had a weighting of more than 70 per cent in the benchmark MSCI Asia equity index.
In 2001, MSCI launched its Asia ex-Japan index that carved Japan out of the region’s main equity gauge. This provided investors with an index that was not dominated overwhelmingly by a single market, allowing traders to exploit opportunities in other parts of Asia without being exposed to prolonged stagnation in Japan.
More than two decades later, calls for “Asia ex-China” investment products are growing louder. While MSCI introduced an emerging markets index that excludes Chinese stocks in 2017, “the roll-out of an [emerging market] ex-China product suite has been limited since then,” Goldman Sachs noted in a report published in October 2021.
A confluence of factors has given fresh impetus to the Asia ex-China theme in markets. China’s weaker-than-expected recovery from three years of self-imposed isolation has unnerved investors and led to a flurry of downward revisions to growth forecasts. Pessimistic views of China’s economy abound, fuelled by persistent concerns about Beijing’s regulatory clampdowns and the reshaping of global supply chains.
A three-month-long reopening rally petered out in February, leaving the CSI 300 index of Shanghai and Shenzen-listed shares 33 per cent down from its peak in February 2021. The results of Bank of America’s latest global fund manager survey, published on June 13, revealed that an underweight position in Chinese stocks was one of the most popular trades in markets.
By contrast, several other major Asian equity indices have performed strongly this year. Indian stocks have surged to a fresh high, powered by a bright economic outlook and resilient corporate earnings. South Korea’s technology-heavy Kospi index has entered a bull market, buoyed by the recent burst of enthusiasm for artificial intelligence.
According to data from Bank of America, inflows into the equity and debt markets of Asia’s main developing economies excluding China in the first five months of this year reached their highest level since 2019.
Even Japanese stocks, which have yet to surpass their bubble-era peak, hit a 33-year high. This is mostly because of long-awaited corporate governance reforms and hopes that policymakers have banished deflation once and for all. Yet, some investors view Japanese shares as the best ex-China alternative in Asia given the depth and liquidity of the country’s stock market.
An electronic stock board showing the Nikkei 225 Stock Average figure displayed inside the Kabuto One building in Tokyo, Japan, on June 1. Japan is seeing ongoing surge in foreign demand for its equities. Photo: Bloomberg
However, the increasing popularity of the Asia ex-China theme needs to be put into perspective. First, the separation of Japan from the rest of Asia’s equity markets came at a time when its economy was a basket case and investors were seeking more exposure to growing opportunities in Asia’s emerging markets.
Two decades on, the economic and financial landscape has changed dramatically. China is the world’s second-largest economy, a crucial engine of consumption growth and the largest e-commerce market. Even if China expanded by just 2 per cent between now and 2030, it would add the equivalent of India’s entire economic output today to its gross domestic product, according to data from McKinsey.
Moreover, China’s weighting in MSCI’s Asia equity index is just above 20 per cent, slightly more than the share of India and South Korea combined. The Asia ex-China narrative is not a “sell China” story but a “China proxies” one – an attempt to find new ways to gain exposure to China without being directly invested in the country.
Second, the Asia ex-China theme catches on whenever risks in China escalate but gains little traction when sentiment towards China is upbeat. Judging by some of the recent reports on Asian equity markets by Wall Street banks, there is an inescapable feeling that the more bullish tone on Asia ex-China is designed to underpin positive views about the region as a whole to compensate for overly optimistic assessments of China at the beginning of this year.
Third, proponents of the Asia ex-China theme should be careful what they wish for. Most of the markets viewed as attractive alternatives to China have their own vulnerabilities that stem mainly from their greater sensitivity to global financial and economic conditions.
People watch the stock market index on a display screen on the facade of the Bombay Stock Exchange building in Mumbai. Photo: AP
Morgan Stanley, which is bullish on Asia ex-China, recognises these risks. In a report published on June 4, it conceded that in the event of a full-blown recession in the United States – which has become more likely as interest rates continue to rise – Asia would “not be able to stay immune and would recouple with the US on the way down”. This is partly because many Taiwanese, South Korean and Japanese firms derive a relatively high proportion of their revenues from sales in the US.
While many investors are looking for ways to hedge against risks in China, it is financial threats in the US that could pose a greater risk to many Asian economies because they have a bigger impact on the global economy and markets. The Asia ex-China theme might hold appeal for some investors, but China’s economy is not the only threat to the region’s stock markets.
