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.
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