Emerging Markets - China and beyond?

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Chinese equities now account for about 40% of the MSCI Emerging Markets Index and as domestic A share inclusion accelerates, we believe the country’s importance for global investors may continue to grow.¹

For an emerging markets investor coming to the China market, the approximately 4000 domestically listed companies almost doubles the investable Emerging Markets (EM) universe. This also allows them to tap into previously challenging-to-access industries that serve the needs of the 1.4bn population², such as cable and satellite companies, drug retailers, and white goods and home appliance manufacturers.

We spoke to Gordon Fraser and Stephen Andrews of BlackRock’s Global Emerging Markets Team about what the rise of Chinese equities means for emerging market investors and how they see this shift benefitting portfolios going forward.

There is no guarantee that a positive investment outcome will be achieved. Reference to individual investments mentioned in this communication is for illustrative purposes only and should not be construed as investment advice or investment recommendation.

The domestic Chinese equity market shares very similar investment characteristics with the broader emerging markets universe. Most notable is the diversity of the opportunity set as well as the breadth of drivers that can influence stock performance.

While China is a single market, each sector can be sensitive to a very different set of factors. Policy and regulatory direction, as well as shifting financial conditions that can influence the market, can significantly impact returns. By framing sector allocation decisions through that lens, investors can seek to improve the effectiveness of their active strategies.

As of Q2 2020 we have been looking more closely at sectors that we believe will benefit from fiscal stimulus and China’s spending in fixed asset investment, particularly through infrastructure projects and support for the healthcare sector. To that end, we believe select opportunities in the cement and building materials sectors look interesting. Elsewhere, while parts of the healthcare sector have gotten more expensive given a broad re-rating in the face of the COVID-19 crisis, we still feel there is a longer-term case for companies ranging from medical device manufacturing to healthcare facilities, medical personnel, and biotechnology.

On the other hand, our outlook on banks has become more negative. State-owned institutions may be requested to help support small and mid-sized businesses, while further monetary easing will put additional pressure on net interest margins. In the consumer space, we believe that earnings cuts have yet to be fully realised, resulting in more cautious risk taking. We are focusing on companies that may benefit from a structural change in consumer behaviours and have been targeting industry leaders that are able to withstand near term volatility and gain market share. Cloud-based software, online education, ecommerce and food delivery platforms are all areas that have piqued our interest.

There is no guarantee that a positive investment outcome will be achieved. Reference to individual investments mentioned in this communication is for illustrative purposes only and should not be construed as investment advice or investment recommendation.

From an emerging markets context, it’s important to recognize that there are more than two dozen countries that comprise the universe, all operating under unique macroeconomic and political circumstances – what is happening in Russia and Brazil has very little bearing on the Indian or Indonesian markets. This provides a level of natural diversification not seen as prevalently in other asset classes, as markets react differently to external pressures based on their current account, trading, and currency positions.

While the extent of COVID-19 impact remains unclear and geopolitical tensions between the US and China persist, we are still able to find pockets of value across the broader EM landscape. Furthermore, as investors focus more attention on larger economies like China, research coverage in the smaller markets continues to decline, presenting a greater asymmetric risk/reward profile for those who are willing to look.

By tracking where countries are in their economic cycles and understanding the potential for an improvement or deterioration in macro conditions, we can seek alpha by finding the right stock-specific ideas but also through effective risk allocation into markets that we think will outperform.

An example of this idea that not all emerging markets are created equal, took place earlier in the year. As COVID-19 uncertainty led to a flight to safety, traditional carry countries – markets that run large deficits and fund their budgets primarily through foreign capital flow – were among the hardest hit. Today, we believe areas like India and Indonesia are looking increasingly attractive. Unprecedented levels of global stimulus should provide ample liquidity, while higher rates should not only incentivize a pick-up in foreign flows but also offers policy makers more flexibility to ease further. Conversely, it is our opinion that areas like South Korea and Taiwan, are likely to remain under pressure due to flat rate structures and persistent technology supply chain disruption.

In both cases, it is our opinion that by aligning top-down and bottom-up conviction you may be able to achieve greater return consistency through market cycles. Outside of Asia, Russia’s low debt position has provided some insulation from capital outflows and going forward can act as a direct play on an oil recovery. In Mexico, while we remain cautious on growth, we see improving economic trends including increased market share of US exports and a good set up for rates to come down further. Subsequently we have identified opportunities to take advantage of recent equity and FX weakness to buy into quality businesses at very cheap valuations.

Pricing inefficiencies provide early movers with potential for greater alpha extraction

The domestic China A-Share market is no exception to the volatility experienced in emerging markets where about 65% of stocks in the MSCI EM Index have moved at least 40% annually over the past decade and that number jumps to about 80% when looking specifically at the Shanghai and Shenzhen Composite Indexes³. Part of this phenomenon is based on the structure of the Chinese market as foreign ownership remains very low, hovering around 3.4%⁴. We have observed that this, coupled with retail’s dominance over trading volumes (~ 82%)⁵ and low levels of formal stock research coverage, has resulted in significant pricing inefficiencies, allowing participants to potentially reap greater levels of alpha through time.

The below chart illustrates this phenomenon. On an annualized 5-year basis, the median active US manager had underperformed the S&P 500 Index by -1.1%, while top-quartile managers only generated +0.4% in excess returns. When looking at EM and China offshore, the alpha generative power of active managers trends better against their developed counterparts, with median performers generating positive alpha over the same time period (+0.5% vs the MSCI EM Index and +1.3% vs the MSCI China Index, respectively). However, the China A-Share market is in a league of its own. While the category is still in its infancy, the median active manager produced +11.1% in annualized excess returns over a 5-year horizon, while bottom-quartile managers were still able to extract +9.6% alpha per annum, over the same period against the MSCI China A Domestic Index. As outlined in the footnote below, this analysis, limitations of this analysis may include sample size and time horizon bias.

Active Manager Excess Return Dispersion by Category (5yr Annualized)

While we firmly believe that thematic investing lacks long term predictive power for asset returns, we do acknowledge that shifting trends may potentially uncover new opportunities. Here are a couple ideas to think about as we inch closer to a world post-COVID-19:

• Global vs local: Geopolitical tensions between the US and China have increased and are expected to persist ahead of and through the upcoming US elections. While deglobalization will put pressure on supply chains, it may also pave the way for domestic manufacturers to flourish as self-sustainability becomes a focus.
• Technology to power in a low-contact world: The pandemic has dramatically shifted how we interact with one another on a daily basis. With a growing focus on remote working solutions, online education, video streaming, and delivery services, software and technology infrastructure will continue to evolve to meet future demand.
• Travel… for business or pleasure?: As transmission concerns subside from either vaccine availability or a natural decline in cases, we expect leisure travel to make a significant rebound. Business travel, however, may not be so lucky as video conferencing has proven to be a viable and more cost-effective alternative to in-person meetings and events.

¹ MSCI as of end May 2020. Chinese equities weight of MSCI EM Index is inclusive as of domestic and offshore-listed shares. Currently, domestic A-share inclusion in broader MSCI indices remains at 20%. There is no guarantee that a positive investment outcome will be achieved.
² World Bank as of year-end 2018.
³ BlackRock, Bloomberg, as of end Dec 2019. Analysis measures the average % of stocks within the respective index (MSCI EM Index or aggregated Shanghai and Shenzhen Composite Index) moving at least 40% per year between 2009-2019.
⁴ Goldman Sachs as of end March 2020.
⁵ Goldman Sachs, Shanghai Exchange as of end December 2017 (note the exchange has yet to update the figure).