Friday, August 13th, 2021

Time to Separate China from EM

When MSCI was considering how to include China A shares in its global indices, there was a considerable body of investor opinion which favoured keeping them in a separate category from other Emerging Markets. Among the reasons for exclusion were the incomplete nature of financial market reform and the fact that China A and B shares would comprise over 40% of EM’s market capitalisation (not counting Hong Kong). The reasons for inclusion were that this would create a higher sustainable growth rate for the EM index as a whole, that China’s returns were weakly correlated with other EMs and that the volatility of returns was also lower. All three factors contributed to an improvement in the risk-adjusted returns of the overall EM index, and it was this that really clinched the argument (China and the future of equity allocations – June 2019 www.msci.com/documents/10199/f6dc426e-96bd-71c2-e2a7-fa1fc9d3be6e).

The last major increase in the weight of China came over the course of 2019. Since then, the performance data have fluctuated. Over the two years, China has outperformed Emerging Markets ex China, but over the last year it has begun to lag badly and this is the period which coincides with the regulatory crackdown. There has also been a significant crackdown in Hong Kong, albeit more political than economic.  In the light of this, we no longer think it makes sense to treat these two territories separately. According to FactSet, 75% of the revenues of all Hong-Kong listed companies are derived from the Chinese mainland. We also doubt that China will allow the Hong Kong dollar to exist as a separate currency indefinitely. Over the last two years, the risk-adjusted returns of China + Hong Kong (C+HK) are almost the same as the rest of Emerging Markets (EMxCHK), but over the last year they are much worse. Greater China doesn’t automatically enhance the returns of Emerging Markets.

Rather than putting 20% of large cap A shares into a global EM index, it seems better to create a new benchmark index for all Chinese equities, irrespective of where they are listed, (also including mid-caps) and keep it separate from the rest of EM. It gives everyone more flexibility. Global investors who are worried about China’s human rights or ESG record can choose to be benchmarked to an EMxCHK index. Investors who think these issues are manageable would have the tactical flexibility to switch between the two indices, while those who wish to specialise in C+HK can do so without having to constantly reference their performance to other EMs. If the Chinese government is going to renege on its obligations to international investors, there should be a readily available EM index (and an ETF) allowing passive investors to avoid exposure to any territory/company which may be affected.

We have proxied how these indices would have behaved and we find that the flexibility of having two separate benchmarks would have been very useful over the last two years. Our recommended weight for C+HK (vs the World ex US) held up well during the global sell-off in March 2020, while EMxCHK fell consistently to a substantial underweight in February 2021. Since then, the situation has reversed dramatically, C+HK is now close to maximum underweight, while EMxCHK has rallied strongly and is now in neutral territory. The performance of C+HK has masked the beginning of a strong and actionable rally in India, Eastern Europe and Mexico. Emerging Markets still face many challenges, but the situation is a lot better than it appears, once we strip out China.

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