The emerging-markets puzzle

For a long time, investors had lumped Chinese stocks and other emerging markets together in the same pot and viewed them as being the same bet – a bet on global economic growth. But China appears to have decoupled in recent quarters – to the downside: the country’s poor stock-market performance has been accompanied by less-than-encouraging macroeconomic data and mounting (geo)political risks. An increasing number of investors by now are viewing China and the rest of the world’s emerging economies as standalone asset classes. Rightly so? In the following article, we’ll attempt to solve the emerging-markets puzzle.

Two variants of emerging markets

When China gets up and running, so do the other emerging-market countries – and vice versa. This correlation long applied to emerging-market equities. Stock prices were also closely correlated for the most part with net capital inflows and outflows. But for three years now, a decoupling of China from the rest of the world’s emerging-market countries has been observable, and the divergence increased further in 2023. Whereas the MSCI Emerging Markets ex-China index has treaded water on balance since 2021, the MSCI China index has plummeted by around 50% over the same period. The China bear market has been interrupted only once during that time by a vigorous 60% rally at the end of 2022, which was driven especially by hopes of a burst of economic growth after the end of the pandemic lockdown. During a period of euphoria between November 2022 and March 2023, a net USD 48 billion flowed into the Chinese equity market temporarily.

What happened afterwards, though, was a huge disappointment: Chinese stocks ranked among the worst underperformers in 2023 with an aggregate share-price decline of 11% for the year, and the disillusioned investors withdrew their previously invested capital almost entirely by year-end. The performance of emerging markets excluding China stands in stark contrast to that. Emerging-markets ex-China were able to keep pace with the developed-market stocks in the MSCI World index both last year and in a comparison over the last five years, at least if strongly outperforming US stocks are left out of the picture. Against this backdrop, it’s no wonder that (institutional) investors are increasingly asking themselves whether Chinese stocks and the rest of the emerging markets are two different kettles of fish and accordingly should be treated differently. Looking at the recent divergence in capital flows, it seems that some investors have already answered that question for themselves. What is the solution to the emerging-markets puzzle? And what are the prospects for the two variants of emerging markets?

Decoupling | China is driving in a different lane

MSCI indices

Sources: Bloomberg, Kaiser Partner Privatbank

Arguments for a (tactical) China bounce…

In any event, investors shouldn’t simply write off China, the world’s second-largest equity market. After three consecutive down years and a negative performance of –60% since peaking in February 2021, now might be the worst possible time to turn one’s back on Chinese stocks because not only are they utterly oversold at the moment, they are also extremely cheaply valued. A valuation premium of +10% versus the rest of the emerging-market countries a year ago (measured in terms of price-to-earnings ratios) has since turned into a valuation discount of –40% at last look. In absolute terms as well, the Chinese equity market’s price-to-earnings valuation multiple of less than 10x is close to its historical low and is at a level that in the past consistently promised share-price gains of more than 20% over the subsequent 12 months. One invariable precondition for that, though, was relatively strong corporate earnings growth. Given the current disinflationary trend in China, it remains to be seen whether corporate earnings can deliver the requisite fuel for a rally again this time. Another precondition for the start of a tactical rebound is in place, though: Chinese stocks have rarely been as unpopular as they presently are – the positioning of mutual and hedge funds is near a five-year low. Economic growth expectations for China for 2024 are also low and have been heading south lately. Finally, market participants likewise have low expectations about the government of China taking actions to bolster the stock market. If economic growth accelerates out of the blue in the weeks and months ahead, this perhaps would fire the starting pistol for a temporary relief rally in Chinese stocks.

A tactical buy? | Chinese stocks are cheap right now in both absolute and relative terms

Price-to-earnings multiples

Sources: Bloomberg, Kaiser Partner Privatbank

…and structural bearish reasoning

So, in the near term, the prospects for China are more constructive than current sentiment suggests. The medium-term outlook, though, is less inspiring. To wit, China’s potential growth looks set to trend downward toward 4% in the years ahead. This means that in contrast to many another emerging-market country, China soon can no longer be regarded as a genuine bet on economic growth. Moreover, the government of China will probably continue in the years ahead to place top priority on structurally transforming the country’s economic model and reducing financial risks. Beijing is unlikely to fire a bazooka to stimulate the financial market solely to placate investors (and speculators).

Meanwhile, Chinese authorities’ regulatory attitude toward the biggest companies in the MSCI China index remains unpredictable and is downright hostile at times. After sending repeated signals last year that the crackdown on the technology sector is over, the regulatory authority sprang a surprise in late December with a draft regulation that would restrict consumer spending on online gaming (and which sent shares of gaming operators tumbling). The political climate in China is structurally challenging also for stocks other than internet platforms. Although Beijing’s industrial policy has chalked up successes, for example in electric vehicle manufacturing, it is also creating adverse side effects. For one thing, it is causing production overcapacity and disinflation, which are cutting into corporate profits. Moreover, the industrial policy heavily relies on financing via the stock market. Consequently, initial public offerings and secondary stock issues to raise further capital soak up more money than flows back to shareholders through dividends and stock buybacks, acting as an implicit brake on performance.

China’s crisis-wracked real estate market, in turn, still hasn’t hit bottom yet, a fact that will continue to gnaw away at consumer and investor confidence. As long as this key economic sector hasn’t found a new equilibrium, a long-term upward valuation rerating of the Chinese equity market seems rather unlikely. But the structurally bearish line of reasoning for China doesn’t end there. There are also (geo)political issues such as the rivalry between China and the USA, as well as the Taiwan question. The impact of these risks on Chinese businesses and China’s stock market are difficult to model. China has already lost allure for foreign investors, as evidenced in the meantime also by data on foreign direct investment in the country, which plummeted dramatically and even turned negative in 2023 (foreigners withdrew net capital). More and more institutional investors in the future are likely to view China as being more of a trade than an investment, also on the equity market – a trade, to boot, that’s hard to time and depends on the benevolence of the government in Beijing. Against this backdrop, more than a few investors will probably use a potential rally in the months or quarters ahead to unload positions in China and rotate into other emerging markets. A closer look reveals that this process has been underway for quite a while now, as exemplified by the iShares ETF on the MSCI Emerging Markets ex-China index, whose asset volume nearly tripled last year while the iShares MSCI China ETF registered net outflows.

Change in favorites | Investors are voting with their feet

Assets under management in iShares ETFs (in USD billion)

Sources: Bloomberg, Kaiser Partner Privatbank

What’s inside the Emerging Markets ex-China wrapper…

But what do investors actually acquire when they buy emerging markets without the inclusion of China, the hulk that dominates in the conventional MSCI Emerging Markets index with a weight of more than 26%? The answer is at least interesting. The MSCI Emerging Markets ex-China index remains heavily dominated by Asia – the top three countries alone (India, Taiwan, and South Korea) are all located in Asia and together make up almost three-quarters of the index. At the same time, the emerging markets ex-China universe is even more tech-heavy (27.7% vs. 22.1%) while consumer goods and telecom stocks in particular become less important. Consequently, the narrower index will tend to be affected more strongly by the economic cycle in industrialized countries and less affected by typical emerging-market drivers. However, the altered risk and return characteristics are even more interesting because when China is stripped out of the emerging-markets universe, one bids adieu to a sizable chunk of risk (volatility). During the period from 2001 to today, the observed volatility of the MSCI China index, for example, has been around 50% higher than that of the MSCI Emerging Markets ex-China index but with only a marginal outperformance at the same time. There’s a lot suggesting that better long-term risk-adjusted returns without China in the mix will continue to be achievable in the future.

A bet on economic growth | Asian countries (and technology) dominate even without China

Sector composition of MSCI Emerging Markets and MSCI Emerging Markets ex-China indices

Sources: MSCI, Kaiser Partner Privatbank

…and is now the time to jump in?

Whether emerging markets ex-China will be able not only to keep pace with but even outperform developed-market stocks in 2024 will depend in good part on whether US technology stocks continue their strong run. The prerequisites for a solid performance are at least in place. For instance, emerging economies’ growth premium versus industrialized countries looks set to climb to the highest level in five years in 2024. The end of the rate-hiking cycle in the USA, the prospect of a return to interest-rate cutting soon, and a prospective weakening of the US dollar round out the positive macro setup. Asia additionally is bound to benefit from a reallocation of global trade and production chains away from China (keyword: de-risking). Exporters of raw materials also look set to profit – from growing demand for the critical input materials needed for a successful climate turnaround. One fly in the ointment, though, is the fact that many of the emerging-market countries that look attractive on paper – including India, Mexico, and Vietnam, for example – already have a lot of advance praise priced in. And last but not least, although China stands squarely in the spotlight when looking at (geo)political risks, a Trump 2.0 scenario, under which a 10% tariff on virtually all imports to the USA (regardless of the country of origin) would potentially loom, would also be harmful to the rest of the emerging-market countries.

Puzzle-solving instructions

Just like there’s more than one path to solving a real, hands-on puzzle, our emerging-markets puzzle likewise allows us to derive multiple conclusions:

• The time to sell Chinese stocks is: not now. A technical retracement is very probable in the near future. Whoever would like to reduce investment exposure to China should wait for that to happen first.
• The timing for overweighting emerging markets ex-China also is not ideal at the moment. Although the fundamentals are very constructive, many markets are overbought and ambitiously priced. A neutral allocation to the MSCI Emerging Markets ex-China index is appropriate right now.
• Anyone who (compulsorily) maintains a strategic allocation to emerging markets and implements it via the MSCI Emerging Markets index holds concentrated China risk and is implicitly exposed to China’s structural problems and to Chinese stocks’ high volatility. It would be advisable for such investors to adjust the benchmark (e.g. to 50% MSCI Emerging Markets and 50% MSCI Emerging Markets ex-China) and to reduce exposure to China. Whoever doesn’t have to be mindful of tracking risk with regard to the MSCI Emerging Markets index can exclude China entirely from the investment universe.
• Whoever isn’t compelled to invest passively should bear in mind that emerging markets are less efficient than the markets in most of the industrialized countries and open scope for outperformance through active management. Partial implementation of exposure to emerging markets through actively managed investment products should be taken into consideration.
• Despite the comprehensively described risks, China also continues to present opportunities. Investors can capitalize on some growth themes – such as China’s rising middle class, for example – also indirectly via developed-market stocks (luxury goods stocks in this case).
• The Chinese equity universe is a veritable alphabet soup ranging from A- and B-shares to H-shares and extending to red chips und P chips. The performance of the respective market segments varies greatly at times and is bound to continue to present alpha opportunities in the future for those investors who possess the expertise and access to exploit them.

Chinese alphabet soup | From A-shares to Red Chips*

Five-year performance (in US dollars)

Sources: Bloomberg, Kaiser Partner Privatbank

* China’s stock alphabet soup explained:

• MSCI China: A/H/B shares, Red Chips, P Chips and ADRs
• A-shares: companies based in China, trading on the Shanghai and Shenzhen stock exchanges, access via Stock Connect
• H-shares: large and medium-sized companies based in China, listed in Hong Kong
• B-shares: companies based in China, trading on the Shanghai and Shenzhen stock exchanges in foreign currency
• Red chips: large and medium-sized Chinese companies based outside China, listed in Hong Kong, typically state-owned enterprises (SOEs)
• P Chips: same as Red Chips, non-state-owned
• ADRs: traded in the USA (NYSE, NASDAQ)