Friday, August 27th, 2021

China vs US Exceptionalism

At the index level, we find that the two-country model has underperformed the US index by just over 25% and that most of this underperformance took place between 2010 and 2017. Since then, the performance has been range-bound, with the current relative index level being about 7 percentage points above its 2017 low. However, the results for individual sector vary widely. The best model is Technology, where the two-country sector model has outperformed the US sector. But it has fluctuated in a wide range since 2014 and is now close to the bottom of that range. The worst model is Small Caps, where the two-county model has consistently underperformed, with no tradeable rallies in the entire 11-year history. Financials, Industrials and Telecom are almost as bad, but each of them has had at least one tradeable rally during this time

Our last two notes have been very sceptical about the investment potential of Chinese equities. We believe that the regulatory crackdown across so many sectors increases the likelihood that China will fail to escape the middle-income trap that has impacted some other Emerging Markets. China’s recommended weight in our global equity portfolio is close to zero and at its all-time low. This obviously creates a situation which contrarian investors find extremely interesting, so it is worth taking a closer look at how and when diversification into Chinese equities has benefitted global investors.

At the same time as Chinese equities are close to maximum underweight, our recommendation for US equities is close maximum overweight. We recently heard one US money manager on Bloomberg argue that he was happy with no international equity exposure at all – and no US Treasuries either. His portfolio was mostly US equities, with a small allocation to US credit and more cash than usual. In the short term, we agree with him, more or less. The difference is that he was proposing this as a long-term strategy, whereas we believe that this will go badly wrong at some point in the future and the only interesting question is when.

US Equities have been the best performing asset class over the last 25 years, but they still don’t beat our tactical asset allocation model. Every time they have got close to it, there has been a correction. Diversification via fixed income and international equities is fundamental to our process and Emerging Markets are an integral part of this in both main asset classes. Indeed, a model with only US and EM Equities and US and EM sovereign bonds outperforms our tactical asset allocation model by over 2 percentage points a year, even though this model can also invest in European and Japan equities as well as the full range of US credit.

This brings us back full circle to the issue of China, which now accounts for over 45% of the capitalisation of the EM index. In our last note, we argued that investors should split their allocation to EM Equities in two: China and EM ex China. India, Mexico and most of Eastern Europe, are currently rated overweight and we are happy to repeat this recommendation. But it is still worth asking the question whether there is any segment of Chinese equities which can be successfully used to diversify a global equity portfolio.

Our approach is to look at each of the ten major sectors and see whether our systematic approach – allocating between US and Chinese equities on the basis of prevailing risk and return conditions – would have beaten the performance of the US equity sector on its own. We also look at Small Caps and the index as a whole. We have to be a bit careful about timescales as well. We disregard anything before China began to liberalise its exchange rate regime in late 2005. These reforms prompted a surge in the outperformance of all the two-country sector models, which lasted until the global financial crisis. It would be unfair to evaluate these models starting from a local peak, so we have chosen January 1st 2010 as our inception date, by which time the new US monetary policy regime was well understood, as was the Chinese response to it.

All of the two-country sector models, apart from Technology, have underperformed over the period since inception, but some of them have performed much better in the recent past. Consumer Staples has outperformed strongly since the beginning of 2020, but peaked in February 2021 and has since retraced about half of its gains. Energy has been in an uptrend since 2017, but has been erratic in the last two years. Consumer Discretionary has also been in an uptrend since 2017, but it is much more stable, though not as powerful. Materials has been in an uptrend since 2020 and has broken out of the downtrend which has been in place since 2010.  Healthcare has performed strongly since 2020, but may have reached a local peak.

On the pages which follow, we publish the relative performance charts for all ten sectors plus Small Caps and the overall index. These compare the total return in dollars of our two-country model vs the US sector. The two-country model switches between the US and the Chinese sector on the basis of our normal probability-based approach.

Conclusions: We believe it will be several quarters before Chinese equities provide successful diversification for a portfolio of US equities or a global balanced portfolio. As previously mentioned, we do not believe this should deter investors from looking at other Emerging Markets. If you must invest in China earlier, we recommend that you avoid exposure to Financials, Industrials, Telecom and Small Caps. We see no reason to bet against such well-established downtrends.

We believe that the best opportunities lie in Technology, Healthcare and Consumer Staples, but we are concerned that now is not the right entry point. If you have to invest today, we would recommend you look for opportunities in Energy, Materials and Consumer Discretionary. On balance, we believe you should wait for the right entry point in the sectors we like.

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