Are emerging market equity strategies a bet on China?

Charlie Wilson December 08, 2020 10:17

A question we’re often asked is whether emerging market portfolios are effectively a bet on China and its more than 400 million middle-class consumers? To degrees it is, and for good reason.

China grew 4.9% in the third quarter from the year before as it rebounded from the coronavirus pandemic. It drives about one-third of global GDP growth. Based on purchasing power parity, China’s share of global GDP is nearly 20%, while almost 14% of global exports come from the Middle Kingdom.

China’s domestic market capitalization on the key exchanges in Shanghai and Shenzhen amounts to $10.7 trillion. Publicly listed Chinese companies onshore, in Hong Kong, the U.S. and Europe number about 4,900. Many are having a great year. After the Nasdaq Composite Index, China’s CSI 300 Index is the world’s best performing major equity benchmark with a 15% return by late October, lifting the broader emerging markets index to a 4% gain.

While much is made of the predominance of mega-cap tech stocks in U.S. equity benchmarks , an equal, if not greater, challenge is managing the predominance of both tech and China in the MSCI Emerging Markets Index.

Information Technology comprises 19% of the MSCI Emerging Markets (EM) Index, while Consumer Discretionary makes up 20% and Communication Services nearly 13%. But the tech-related names in the latter two sectors are led by mega-cap e-commerce and payments giant Alibaba Group, food delivery and online shopping platform Meituan Dianping and social networking and gaming platform Tencent Holdings, all three of which are Chinese. In fact, while tech and tech-related names in the index approach nearly 40% of the EM benchmark, on a geographic basis China alone accounts for 42% of the bench, which groups large- and mid-cap stocks from 26 emerging markets.

Diversifying While Keeping Your Balance

The EM benchmark is not the starting basis for our portfolio. First, we identify the strongest companies operating in emerging markets and wait for them to present themselves attractive valuations. Emerging market equities often disconnect from their underlying fundamentals. We then ensure we have enough capital behind our highest-conviction ideas. Thanks to the depth of its capital markets and the size of its economy, many of the best EM opportunities are domiciled in China.

This isn’t too different from the U.S.’s role in global benchmarks. China also has many unique, world-class companies that, depending on valuations relative to our expectations for long-term earnings power, may be multi-year portfolio holdings. Still, we actively diversify not just across geographies, sectors and market caps, but also styles through our basket structure.

Our baskets group three types of stocks: basic value, in which companies exhibit more earnings volatility; consistent earners, which exhibit less earnings volatility and more visibility; and emerging franchises, which are carving out new markets or displacing incumbents as they are either growing faster or have the potential to grow at above-average rates. The baskets help us stay on top of relative value changes in turbulent times and across market cycles. The portfolio may be overweight or underweight certain sectors or countries at any given time but won’t be offsides on our basket parameters. That discipline is both defensive and offensive, signaling when it’s time to reallocate after a good run to segments that have greater upside potential.

In emerging markets value- or growth-classified stocks often become correlated across countries and sectors. “Style risk” is a particularly important source of benchmark-relative risk. Consistent allocations to our three baskets help mitigate this type of volatility. And when correlations spike and good companies become mispriced across regions and sectors, opportunities arise.

The challenge of a more concentrated portfolio is that it often deviates from index sector and country weights, in theory leading to higher benchmark-relative volatility. Yet because value or growth stocks often become correlated across countries and sectors, style risk is an important source of benchmark-relative risk. That’s why our primary focus in constructing a concentrated portfolio is to balance value and growth investments relative to the emerging market universe.

We may also hedge currency exposure to mitigate currency-related volatility, though the currencies with the most challenging fundamentals typically cost the most to hedge. So, we incorporate currency considerations into our bottom-up research process to estimate the potential impact of macro volatility on expected returns. This also creates a framework for comparing opportunities across markets with different economic fundamentals.

This year, the renminbi has appreciated about 4% against the dollar, signaling China’s strong economy and resurgent growth and bolstering the strong returns of many Chinese stocks. Chinese equities certainly merit prominent allocations in emerging market and global portfolios, which should incorporate diversified, yet balanced allocations across sector, geography, and style.

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Charlie Wilson

Portfolio Manager and Managing Director at Thornburg Investment Management