Institutional investors are looking closely at the ability of their emerging market exposures to stand alone from China, according to various consultants and managers.
While emerging economies are affected by many different factors, such as the US dollar, exports and commodities pricing, China dominates the aggregate sentiment and, according to a recent study by State Street, “things have looked horrible of late, especially with President Xi reiterating their top priority to double down on Covid-zero.
“With manufacturing momentum stuck in contraction territory throughout 2022, this has coincided with a further EM equity sell-off relative to global counterparts. Beijing has pledged to remain active in stabilising the financial market, but who knows when we will actually see the growth story stabilise in China.”
With specific reference to this China dynamic, discussions are starting to happen more and more with investing institutions, Rossen Djounov, managing director for Asia at GAM, told AsianInvestor.
“China is a very big economy and potentially a huge investment opportunity, so they are considering it might be better to carve it out of the EM basket,” said Djounov.
Jean De Kock, strategic research director for AMEA at Mercer confirmed that EM ex-China has been been a topic of discussion with clients.
“China is a strategically important market which offers strong diversification and rich alpha, so one advantage of an EM ex-China mandate is that it allows investors to size their China allocation appropriately and take advantage of the alpha opportunities via specialist China managers.”
Another advantage is that smaller emerging markets may be neglected within broad EM mandates, but managers are more likely to focus on these markets as significant sources of excess returns within EM ex-China mandates, said De Kock.
Historically, Asia 'quality' assets have outperformed the broad market with comparable volatility, according to Wilson Chen, managing director for public equities at Cambridge Associates.
“However, these companies generally tend to command a valuation premium, and the sharp rise in global interest rates has led to a repricing of quality stocks, causing performance to trail that of broader Asia and global equities year-to-date."
“Valuations having declined from previously stretched levels, are now low in both absolute and relative terms. Thus, we believe client portfolios should benefit from the addition of quality characteristics, given reasonable valuations and the defensive profile of underlying names.”
The question then is how to properly weight China.
Mercer argues that, broadly speaking, China’s onshore equity market is significantly under-represented in global equity benchmarks. For example, MSCI’s inclusion factor of 20% for its ACWI.
"We believe an allocation to China A-shares in the range of 5-10% of an investor’s total equity portfolio is therefore appropriate. This should be considered against China’s ~18.5% share of World GDP in 2021.
For context, the US accounts for ~24% of World GDP (2021) but over 63% of the ACWI.
"But even putting notions of economic representation aside, higher allocations to China are justified by the portfolio efficiency benefits of diversification and alpha," said De Kock.
One approach to optimise China exposure is to top-up the China element within a broad EM mandate via a dedicated China A-shares or All China equity allocation. Another is to carve China out of EM, in a structure with separate EM ex-China and All China allocations.
From a fixed income perspective, De Kock sees less of a rationale for separating out a China onshore bond allocation.
“In the past, our view has been driven by the fact that a significant portion of onshore fixed income returns have been driven by exposure to the Rmb, and that this exposure is best captured through an equity allocation.
“However, more recently, we have seen the potential diversification benefits of an allocation to Chinese government bonds (CGBs) to capitalise on stark policy divergence from the rest of the world. This is likely to persist for some time yet, and opportunistic investors might see a place for Chinese onshore bonds in their defensive toolkits.”
Indeed, CGBs are the only sovereign bond market to enjoy positive returns year-to-date in local currency terms. The attractive diversification potential needs to be re-evaluated, though, as Western economies near their terminal policy rates, and also balanced against ESG considerations.
Removing or reducing China exposure from portfolios may not be the most effective response to rising geopolitical risks, said De Kock.
This is partly because it would only provide limited protection across a broad spectrum of worst-case scenarios, while foregoing potential portfolio efficiency benefits across numerous benign scenarios.
It is perhaps surprising that this approach of stripping out China from EMs is largely undeveloped by the fund management community. Few managers have any dedicated assets and most managers do not have any fund vehicles available. According to Mercer's Global Investment Manager Database, there are three rated managers with a track record in the space.