Celebrations to mark a new year in the Chinese lunar calendar have been understandably muted this year in the face of the recent outbreak of the coronavirus, which has resulted in widespread loss of life, shut down airports, halted trade and led to the rapid construction of new hospitals in China. The effects of the outbreak will push the country’s economy into a period of slower growth, with stocks trading lower as investors seek protection.
China is now the dominant exposure in some well-followed global emerging markets equity benchmarks with a weight of approximately 34% – so what does that mean for the majority of portfolios that have direct or indirect exposure to the country?
And how might we make a reasonable assessment of the potential impact of the coronavirus in relation to all the other factors an investor must factor in? Will, for example, the collective impact of the outbreak – fewer flights, less trade, reduced productivity and so forth – affect a few businesses, a few industries or entire markets?
A-share index inclusion requires fresh approach to China
Our own answer, at this stage, is to be alert but unassuming. It should be noted there is no ‘safe’ approach for investors here – for example, exiting stocks in favour of cash has its own risk, namely crystallising any losses suffered to sentiment while almost certainly missing out on a rebound if the virus were to be contained quickly. As such, we would want to proceed by contemplating the effects of what we consider to be the most likely scenario, while taking other possible outcomes into account.
Remember – this has all occurred on the back of a combination of trade wars, unrest in Hong Kong, political tension with Taiwan and the slowest economic growth in 30 years. These have all competed for attention in the minds of investors.
At the same time, one of the most significant events for investors occurred far more quietly in the computers of index providers and passive fund managers, as the representation of China’s A-share market quadrupled in some emerging-markets indexes. This not only makes China too big to ignore for investors, but is a key consideration when investing in broad emerging-markets funds that are likely to have a sizable holding in Chinese markets.
One of the least attractive equity markets
When viewed through a long-term valuation-driven lens, our research suggests China is one of the least attractive equity markets in either the emerging or developed world. One of the reasons for this unattractive profile is the high exposure of the Chinese market to expensive consumer discretionary and communication stocks.
While such businesses have benefited from the rapid economic growth in the Chinese economy over the last 30 years, future growth now appears to be fully discounted in the price of these assets. In contrast, China has less exposure to attractive energy and materials stocks that are more prevalent elsewhere in the emerging markets.
It is important to remember that emerging markets have come a long way since the ‘Asian crisis’ of 1998. Almost 80% of the emerging market index is from countries that were not even investible in 1998. Countries such as Russia and Taiwan have opened up and taken a large amount of market share relative to the 1998 exposure, which was dominated by Malaysia. The same issue also applies by industry – with drastic changes notable.
Country exposure vs diversified EM funds
In light of this, it is well worth taking a more granular approach to allocating capital in emerging markets – and, for our part, we have dedicated exposure to countries such as South Korea and Russia in our managed portfolios, alongside more diversified funds, in order to improve the expected return of both our emerging-markets equity holdings and the portfolios as a whole.
In a similar vein, it is obviously worth considering whether the emerging markets funds you use for your own clients have sufficient freedom to focus on the best-value opportunities or are tied to these recently changed benchmarks.
Taken together, an ongoing allocation to emerging market equities can still be appropriate in the current environment – especially when the US equity market is expensive and presents a heightened risk of loss. Moreover, emerging market equities, on aggregate, offer more attractive valuations than developed markets – but China is not the driving force behind that observation.
Leslie Alba is senior investment analyst, capital markets & asset allocation at Morningstar Investment Management Europe
