In 2021, China’s economic slowdown, zero-COVID strategy, and regulatory interventions led to many negative headlines. From an investment perspective, we think it’s important to look beyond the headlines at the underlying trends at work in China. Our examination of those trends leads us to believe that Chinese assets remain appealing. At the same time, we think that the Chinese market has evolved to require a differentiated approach. Investors should consider positioning their China exposure on a standalone basis, with a preference for active strategies and an expectation that their China allocation’s portfolio share will grow.
The macro rationale for China investment remains intact. While the country’s growth trend is decelerating, its growth rate will remain far above that of developed markets and slightly above that of other emerging markets. Even if annual GDP growth were to slow to a persistent level of 4% to 5%, this would provide a lot of room for companies to grow their earnings at an attractive rate. Moreover, China’s size means that its companies can take advantage of a larger home market - China’s domestic economy is larger than the economies of all other emerging-market countries combined.
In addition, there are some distinct competitive dynamics at play in China. The country remains a large net creditor, and its unique political system means that it has built up a sizable capital base in the form of hard and soft infrastructure. This capital base should still deliver outsized productivity gains for a country at this income level.
While some of our macro arguments are debatable, our core investment thesis is not. China’s equities market appears structurally undervalued. China’s equities-market capitalization is stuck at 82% of GDP, far below that of any developed market. Figure 1 uses the Buffett Ratio1 to show the comparison. This relatively low ratio provides leverage for China, as we estimate that market-cap-to-GDP should reach 100% by 2025, driven by new stock issuance and the growth of the current market. In addition, cyclical markers also indicate excessive discounting, with China’s current price-to-earnings ratio falling well below 20-year averages and global/developed-market benchmarks.
Figure 1: China’s Equities Market Appears Structurally Undervalued, As Evidenced by Its Relatively Low Buffett Ratio
Buffett Ratio (Market Capitalization to GDP) of Select Equity Markets
Second, despite the size of the China market, global investors currently have relatively little exposure. The economy represents roughly one-sixth of the global economy, but Chinese equities represent only 4% of the MSCI ACWI (on a free float basis). All other EM countries make up about 8% of the MSCI ACWI.2 The bond side looks much the same, with foreign investors owning only 3.2% of the Chinese bond market. By comparison, bond markets in India, Brazil, and Russia have foreign investor participation rates in the double digits, and they represent the most closed markets among the G-20. All of these China figures reflect several years of net capital inflows, as well as inclusion in major indices.
Third, Chinese assets retain very low correlation to other markets and maintain excellent diversification features. The pandemic illustrated how much China follows its own economic cycle and its own policy priorities. Limited integration with global financial markets also helps to reduce correlation with other markets. And while China’s equity correlation with other emerging markets has picked up in recent years (see Figure 2), it still remains below that of any other comparable correlation pair (its correlation with developed markets has remained low).
Figure 2: Chinese Assets Retain Very Low Correlation to Other Markets
10-Year Monthly Equity Correlations for Select Markets
Such diversification is particularly hard to achieve in today’s investment landscape, and Figure 3 demonstrates that this gap is even more pronounced for Chinese bonds. Exhibiting the lowest correlation among major bond indexes, Chinese bonds clearly do not move with the global monetary cycle.
Figure 3: Chinese Bonds Clearly Do Not Move with the Global Monetary Cycle
Fixed Income Asset Correlations for Select Markets
Based on USD Unhedged Returns
Another strong argument in favor of Chinese bond allocations is that China has maintained a healthy yield premium over developed markets. Given the rebound in global growth, this premium is narrowing from its recent highs, but it is still likely to October 29, 2021. The combination of yield premium and modest volatility makes Chinese Treasury and Policy bonds outliers in terms of the risk/return ratio among most bond indices (see Figure 4). The question of exchange-rate risk remains, but here, too, policy objectives have clearly sought to maintain stability. The real effective exchange rate has remained within a 6% range for more than five years, the longest stretch since China’s economic liberalization. China’s policymakers have the unique ability to engineer exchange-rate stability and have telegraphed their intention to continue to do so.
Figure 4: Chinese Treasury and Policy Bonds Are Outliers in Terms of Risk/Return Ratio
Risk/Return of Major Bond Indices
Given China’s idiosyncratic features compared with other emerging markets, the ongoing evolution of its growth story, and the unique risks involved, we believe that investors would be well-served to give particular, dedicated consideration to China investment. This may include a separate portfolio allocation to China, which would allow investors to tailor and adjust their China exposures to meet their particular return and risk objectives over time. By breaking out China from EM, investors may receive a more favorable return from owning the systematic risk, which is of course higher in a China-only exposure than in a more diversified EM exposure.
1The ratio of total market capitalization to gross domestic product. 2Source: MSCI, as of October 31, 2021.
The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor’s or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The views expressed in this material are the views of State Street Global Advisors through December 6, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.
Images of NYSE Group, Inc. are used with permission of NYSE Group, Inc. Neither NYSE Group, Inc. nor its affiliated companies sponsor, approve of or endorse the contents of this program. Neither NYSE Group, Inc. nor its affiliated companies recommend or make any representation as to possible benefits from any securities or investments.