Emerging markets outlook: China’s economy rebounds, but equities face concentration risk

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Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.  The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

This publication may contain forward-looking statements. Forward-looking statements are statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as or similar to, "expects", "anticipates", "believes" or negative versions thereof. Any statement that may be made concerning future performance, strategies or prospects, and possible future fund action, is also a forward-looking statement. Forward looking statements are based on current expectations and projections about future events and are inherently subject to, among other things, risk, uncertainties and assumptions about economic factors that could cause actual results and events to differ materially from what is contemplated. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements. Russell Investments has no specific intention of updating any forward looking statements whether as a result of new information, future events or otherwise.

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 24 emerging economies.

MSCI AC (All Country) World Index: Captures large and mid-cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 2,791 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 714 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.

CORPCA-00357

The Chinese economy continues to recover from the COVID-19 shock and is now close to pre-pandemic output levels. This is quite a significant feat, given the depth of the downturn in the first quarter, and the fact that the International Monetary Fund expects other large countries won't return to pre-COVID levels until 2022. China’s economy has been supported by several key factors:

  • A more successful experience with containing the second and/or third waves of COVID infections. This has allowed the economy to reopen at a faster pace.
  • A significant amount of fiscal and monetary stimulus. The former has led to a large amount of government bond issuance, which has been funnelled into infrastructure projects. The latter has kept borrowing rates low and provided significant amounts of liquidity to the Chinese economy.
  • Export-oriented industries benefiting from the reopening of the global economy.

The consumption side of the nation’s economy has played catch-up to the production side of the economy. This is a particularly important development when considering the outlook for government policy, given the Chinese government’s focus on the concept of dual circulation. This reflects the desire of the Chinese government to further strengthen domestic demand and accelerate the economy’s shift away from being an export and capital-heavy economy to a consumption-based economy. This is essentially one of the key transitions that is needed to ensure China does not fall into the middle-income trap.

Fiscal policy will remain supportive

The Chinese government and central bank have already been discussing when to start reducing the amount of stimulus. We think what’s likely to happen is that we’ll see a continuation of the hand-over from monetary policy to fiscal stimulus. The PBoC  (People’s Bank of China) governor, Yi Gang, has expressed concern about the level of borrowing that has occurred in response to lower interest rates and increased liquidity—suggesting that further monetary easing is unlikely. However, the removal of support is likely going to be delayed until at least the end of the year, given the need for liquidity from the banks in the final two months of the year.

We think that fiscal stimulus is going to remain supportive through 2021. Infrastructure spending and projects will be key drivers of fixed asset investment. We also think there is the potential for more stimulus to the household at the upcoming National Peoples Congress meeting (likely in March 2021), given the Chinese government’s pursuit of boosting domestic demand.

Global Market Outlook – Q4 update

The Old New Cycle

No return to pre-Trump China-U.S. relations

With the U.S. election now in the rear-view mirror, and the latest vaccine developments looking encouraging, let’s re-examine one of the risks the market has faced over the last couple of years: the U.S.-China relationship. At this stage, it appears that President-elect Joe Biden will likely be more diplomatic in the relationship with China—and less likely to use tariffs as an instrument of engagement. However, we do not foresee a return to pre-Trump era relations with China.

Joe Biden, and the Democratic Party more generally, have been more in favor of multilateralism. With this in mind, we see two key watchpoints that will offer clues to the future of U.S.-China relations. The first will be the initial meeting between Biden and Chinese President Xi Jinping, and subsequent discussions about the future of the current tariffs and the Phase One trade deal. The second watchpoint will be Biden’s attempt (and ability) at forging a multi-country alliance to push China into allowing a better trading environment.

Concentration risk confronts emerging markets equities

After underperforming through the early phase of the COVID crisis, emerging markets (EM) equities have now caught up with global equities (as measured by the MSCI All Country World index). However, MSCI China (which captures Hong Kong-listed Chinese companies) has outperformed by a significant margin, and onshore Chinese equities (for example, the CSI300 index) have seen even stronger returns.

Click image to enlarge

Emerging market performance 2020

Source: Refinitiv Datastream, December 31, 2019–November 13, 2020. China represented by MSCI China Index, World represented by MSCI All Country World Index, EM represented by MSCI Emerging Markets Index. Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future performance.

So, with the Chinese outlook encouraging, and the global economy in the early cycle, it’s not hard to see why some may view this as a great time for EM equities. While we think that valuations currently look fair (compared to expensive in markets like the United States), we do see one key risk, which is that the opportunities in EM may be more within the Chinese market specifically, rather than at a total level.

This is because the EM equity index has a very high level of concentration in Chinese companies. China now accounts for 43% of the MSCI Emerging Markets Index—and just over 20% of that is in six companies (Alibaba, Tencent, Meituan, JD.com, China Construction Bank and Ping An Insurance). These companies have done extremely well in recent years—not unlike technology companies in the United States—and now are priced at expensive valuations. 

EM-ex China is improving

While emerging-market economies outside of China still face some challenges, the overall outlook has improved. First, increased vaccine procurement by groups like COVAX is encouraging. Second, while the fiscal situation remains more challenged than in developed economies, the restarting of the global economy should provide increased external demand, and the resumption of tourism is also likely to be a significant boost.

The bottom line

Amid burgeoning domestic consumption and a signal for continued fiscal support, China’s sharp recovery from the pandemic shows no signs of slowing heading into 2021. Powered by the bounce-back in the world’s second-largest economy, EM equities have rallied during the second half of 2020, but the increasing concentration of Chinese companies in this asset class merits additional consideration.

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.  The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

This publication may contain forward-looking statements. Forward-looking statements are statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as or similar to, "expects", "anticipates", "believes" or negative versions thereof. Any statement that may be made concerning future performance, strategies or prospects, and possible future fund action, is also a forward-looking statement. Forward looking statements are based on current expectations and projections about future events and are inherently subject to, among other things, risk, uncertainties and assumptions about economic factors that could cause actual results and events to differ materially from what is contemplated. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements. Russell Investments has no specific intention of updating any forward looking statements whether as a result of new information, future events or otherwise.

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 24 emerging economies.

MSCI AC (All Country) World Index: Captures large and mid-cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 2,791 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 714 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.

CORPCA-00357