Should pensions & institutions separate China from emerging markets?

The economic conditions that attracted so many investors to China over the past few decades might now be found in other emerging markets. China’s rapid GDP growth has slowed. The country has been negatively exposed to US tariffs since 2018 and has a problematic real estate sector. At the same time, India, Taiwan, and South Korea as well as major Middle Eastern and Latin American economies are showing the rapid GDP growth characteristics that made China such a powerful returns driver in the 2000s and early 2010s. Many emerging market investors are seeking ex-China strategies.

That demand is much of why Mackenzie Investments launched their Mackenzie Emerging Markets ex-China Equity Fund in late April. Arup Datta, Head of Global Quantitative Equity at Mackenzie Investments and lead portfolio manager for this fund, explained why his team is offering this strategy now. He emphasized that his team is agnostic and will continue to offer an emerging markets equity fund that includes China. He outlined, however, some of the risks that the ex-China fund avoids and what additional growth drivers an ex-China strategy is exposed to.

“It is the EM play of 15-20 years back, absolutely,” Datta says of an ex-China strategy. “It has all the other EM countries with all their growth potential…Based on your appetite for allocating towards higher GDP growth, you put that money to work in EM ex-China, and then put China in other buckets. This higher growth/lower growth divide makes the case for perhaps China not being part of your standard EM allocation.”

Datta is not advocating for any particular strategy, nor does he think investors should totally divest from China. Rather he argues that the conditions of high GDP growth that made China an EM leader are now more easily found in other emerging markets. It’s a point he demonstrates through the China allocation in the MSCI Emerging Markets Index. At its peak before 2018, Chinese equities represented around 40 per cent of the index. Today that’s closer to 25 per cent.

That decline is a result of multiple factors according to Datta. The US imposition of tariffs on Chinese imports in 2018 began a broader period of retrenchment in globalization which has negatively impacted Chinese growth. China’s real estate sector has been plagued by structural issues in recent years. Markets are still unsure about China’s approach to its entrepreneurial class following the punishments its government meted out to companies like Alibaba and Tencent.

The rapid GDP growth rate that China achieved in the 2000s and early 2010s, too, simply cannot be sustained when China has already become the world’s second-largest economy. China’s best growth days, Datta says, might be behind it. At the same time, other emerging market economies have begun to exhibit those growth characteristics that made China so attractive once.

India is finally living up to its “unrealized potential” Datta says, and markets are greeting its growth warmly. Taiwan is something of a “one trick pony” but that trick is semiconductor manufacturing, something that investors are very keen to gain exposure to. South Korea, which had long traded under a “Korean discount” is now taking queues from Japan in terms of corporate governance and shareholder-friendly policies, resulting in better market returns. Other traditionally resource-driven emerging markets, such as Saudia Arabia, the UAE, South Africa, and Brazil are diversifying their economies considerably while posting significant GDP growth numbers. Datta notes that Taiwan and India together have posted similar levels of returns to US equities over the past 10-15 years.

That is not to say China doesn’t come with its own growth prospects. The Chinese market is currently trading at less than nine times earnings, which Datta says makes it attractively priced. Over the past three months, too, many Chinese markets have recovered significantly from their recent lows. Nevertheless, there are a host of reasons why investors — especially institutional investors — may want to avoid China in their EM allocations. Beyond the risks outlined above, many individuals and pension members are keen to avoid Chinese investments for political reasons. That’s another factor that pension managers may want to consider.

“A lot of people don’t want to touch China for various reasons. This strategy takes that into account,” Datta says. “If you think of it in a growth vs maturity bucket, that’s where you would want to split up EMs from China. If you want to dictate that allocation it gives you more power than if it was a full EM fund. Portfolio managers can make that allocation.”