DON’T BET THE FARM ON BETTING ON CHINA
Martin Pelletier warns investors to trek cautiously through risky emerging markets.
China is making a lot of headlines these days due to escalating protests in Hong Kong and the ongoing trade dispute with the United States.
However, it isn’t all bad news, especially for those investors who haven’t been scared off by the mounting political risks surrounding the country.
Surprisingly, Chinese equity markets have for the most part performed quite well this year, with the CSI 300 stock index and the Shanghai SSE Composite index up nearly 29.5 per cent and 18.5 per cent year-to-date, respectively.
Both are also ahead of the S&P 500, which is up 18 per cent this year. That said, there are a number of risks worth considering before jumping into such a volatile market, including a slowing-growth environment dominated by mounting trade barriers, anti-globalization sentiment and disinflation fears.
China has no doubt been a leader with its economy expanding at three times the pace as the U.S. over the past decade but this gap is narrowing. For example, it has seen its annual GDP growth been cut from its high of 14 per cent down to six per cent currently.
Many are wondering if this contraction will continue in a world that appears to be headed down a path of less trade, and even potentially becoming disinflationary with negative interest rates now accounting for approximately 30 per cent of the global bond market. Commodity markets and oil and natural gas have also been under heavy pressure as this narrative becomes more readily adopted as the pervasive view.
Consequently, despite this year’s strength, the last decade hasn’t been very kind to investors in emerging markets with lacklustre returns when compared to the U.S. For example, the MSCI Emerging Market Index is still 26 per cent below its 2008 pre-financial crisis high whereas the S&P 500 is up more than 90 per cent.
Perhaps this explains why emerging markets represent only 25 per cent of the total global market capitalization versus 43 per cent of global GDP. China itself represents 28 per cent of global GDP and only 10 per cent of total global market capitalization.
To add some further perspective, we’ve read that emerging market valuations on a price to book value basis have also fallen from its 2008 high of 3.1 times to currently only 1.3 times, which is quite a remarkable contraction. Therefore, while the outlook has become diminished and riddled with risk, one must weigh if it is being reflected in valuations or not.
For those contrarian investors looking to enter the space or add to it, it’s important to understand the dynamics of the investment vehicle first as the underlying currencies and the indexes each are tracking can have varying results. For example, iShares MSCI China ETF (MCHI) and SPDR S&P China ETF (GXC) are up just over eight per cent this year compared to the Invesco Golden Dragon China ETF (PGJ), which is up nearly 12 per cent and the iShares MSCI China A ETF (CNYA) and KraneShares Bosera MSCI China A Share ETF (KBA), which are both up approximately 26 per cent.
Chinese small caps have done poorly with the iShares MSCI China Small-Cap ETF (ECNS) up 22 per cent in April before giving up all of those gains and now being flat on the year.
Here in Canada, the iShares China A Index ETF (XCH), which offers exposure to equities of 50 of the largest Chinese companies by market cap, also had a tough year gaining 16 per cent by April and subsequently giving back most of those gain.
It is now up only 3.1 per cent for the year.
The inner contrarian in us makes us think emerging markets are a segment of the global market worth looking at but it also shouldn’t dominate a portfolio given the level of associated volatility. China itself can also be very difficult one to understand given the dynamics of its government-influenced economy and market so caution is warranted especially in a world where trade walls appear more likely to be going up rather than coming down.