For investors, dedicated allocation can create the right exposure to China
The economic success of China presents appealing investment opportunities in a broad range of sectors; and continued reforms and liberalization efforts have enabled much easier access to its financial markets.
A top question is how investors can gain exposure to China. Most international investors are gaining exposure now via a multicountry portfolio or index. We believe this doesn’t give investors the sufficient or full exposure to China given the country’s economic rise, strong risk-adjusted returns, and unique opportunities.
China deserves a separate allocation despite being classified as an emerging market, or EM, by index providers. Its equity market is the second-largest in the world, well ahead of the third-largest, Japan. Japan is already treated as a distinct asset class.
The Chinese economy is now larger than the GDP of India, Russia, Africa, and Latin America combined, and we believe it will continue to deliver premium growth, going forward. In particular, the COVID-19 crisis has strengthened China’s economic leadership.
China has managed to emerge strongly from the COVID-19 crisis, thanks to effective containment. Real GDP expanded 2.3 percent year-on-year in 2020, making China the only major economy globally that delivered positive growth. Economic activities were strong entering this year, benefiting from continued recovery in both domestic and external demand.
We believe the Chinese economy is poised for long-term structural growth, and the current strengths we see from a broad range of economic indicators will continue. China is repositioning its growth drivers toward consumption and services, which are already the largest contributors to GDP growth.
We expect its consumption market to double its current size by 2030 to reach $17 trillion, supported by an expanding middleincome population and sustained income growth. Policy support is expected to be strong given consumption’s strategic importance to the government’s long-term growth plan. These can enable China to generate sustained expansion, going forward, and to remain the largest driver of global growth.
Risk-adjusted returns
The strong positive economic prospects of China have been reflected in its equity market performance. We compared the return and risk profile of Chinese equities and EMs’ equities excluding China on a five-year basis. Chinese equities delivered a much higher annualized return, and even after adjusting for risk, they have offered a premium over the rest of EMs.
From an index perspective, China’s importance in the MSCI Emerging Markets Index has risen in recent years. Its index weight has increased to around 40 percent now from below 25 percent five years ago. We expect its index weight to keep rising, given faster economic growth and further A-share inclusion.
We have seen the return correlation between China and EMs structurally rising to around 0.9 from 0.6 over the past 20 years. We believe EM equities can become almost indistinguishable from China alone once China’s weight exceeds a certain threshold.
It then may be worth considering having a separate China allocation that can fully capture the entire opportunity set in China. A dedicated China allocation can allow investors to tap into names that are yet to become well known, helping to uncover more alpha sources.
The growth of the Chinese economy has given rise to abundant competitive Chinese enterprises in a broad range of sectors. There are now more than 5,500 Chinese companies that are listed across the Chinese mainland, Hong Kong, and the United States.
We believe they provide a large selection of alpha sources for investors to choose from when constructing their portfolios.
Compared with other EMs, the communication services, consumer discretionary and healthcare sectors together account for above 60 percent of the MSCI China Index while only comprising 17 percent of the MSCI Emerging Markets ex China Index.
Most other emerging markets remain dominated by traditional growth sectors such as financials and materials. We believe the difference in sectoral composition is another reason for having a dedicated China allocation.
Potential pushbacks
First, the impact of COVID-19 on economies. As consumption is gaining importance in driving China’s economic growth, some international investors are concerned about whether China can generate enough employment and income growth to support continued strength in domestic consumption.
From a long-term perspective, the government is placing a growing focus on the quality of growth rather than quantity. Employment is being given priority among various policy directions.
We expect supportive policies to help stabilize and promote employment. Meanwhile, China released its new Five-Year Plan this year and there is strong emphasis on social welfare and improving income equality in the document.
Second, geopolitical tensions with the US. Our team believes the geopolitical tensions with the US will be an ongoing topic. This is in line with many investors’ views. That said, we don’t expect this tension to derail China’s long-term economic progression.
Our view is that it is worth investing in China. The country has a large and expanding domestic market, which is a valuable feature of its economy. This allows China to enjoy unique economic and business cycles that rely on its domestic strength, which will help to shield it from geopolitical complications.
On the corporate level, Chinese companies derive over 90 percent of their revenues from the domestic market and less than 5 percent from the US.
Third, relatively low ESG — environmental, social and governance — standards. China pledged last year that it will reach carbon neutrality by 2060. We believe such an ambitious commitment exemplifies China’s desire to pursue long-term sustainable growth and will propel the wave of ESG development, going forward.
ESG development is already gaining traction in China. We see an uptrend in disclosure rates of these three indicators that are gradually catching up with global and regional standards.
We expect strengthened regulations to drive further improvements in ESG disclosures among Chinese companies. We believe continued financial liberalization to attract more foreign investors will also drive ESG development in China.
In conclusion, we believe a dedicated China allocation is what investors can consider. Besides having premium growth, the country may also offer the benefits of abundant attractive investment opportunities. Its investment universe is deep and diverse and may provide investors with ample compelling opportunities thriving from structural growth areas.
We believe investors can consider adopting an all-share approach while investing in Chinese equities. An all-share approach means selecting opportunities irrespective of listing locations.
We believe both onshore and offshore Chinese markets have unique listed companies and together they represent the complete opportunity set for investors.