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Our research suggests that investors should consider breaking out emerging market (EM) ex-China equities from Chinese equities in their EM allocations. We believe EM ex-China offers the potential for higher returns and lower risk than China, as well as a superior translation of GDP growth to earnings and returns. In this paper, we share the research behind these conclusions, including our observations on:
For investors contemplating a separate EM ex-China allocation, the stock-picking opportunity set is rich from a regional standpoint and steadily improving as economies grow and broaden out. At the same time, as we discuss here, there are biases to keep in mind, including sector concentrations and high revenue exposure to developed markets (DM). In terms of implementation, there currently are not many vehicles available to allocate separately to EM ex-China, but this appears to be changing rapidly, driven by strong demand.
We are often asked whether Chinese and EM ex-China equities should be separate allocations. In our own analysis, we have seen China’s equity market beginning to behave differently from the rest of the EM world based on correlations and common drivers of performance — which we consider to be significant and growing evidence they are not the “same thing”.
Since 2020, EM ex-China has become increasingly disassociated from Chinese growth indicators and market returns. This is evident, for example, in return correlations, which have steadily fallen in recent years. In fact, we find that EM ex-China is more correlated with developed markets than it is with China (Figure 1).
We have also found low and declining similarity in common drivers of EM ex-China and Chinese equities. China’s COVID policy added idiosyncrasy to Chinese economic and market functioning, but that doesn’t fully explain the divergence in common drivers. For example, China’s “common prosperity” policy and other domestic drivers (e.g., controlling economy-wide leverage) have led to more uncorrelated policy decision making, which is closely linked to market results.
As a result of our research on the growing differences between EM ex-China and Chinese equities, we decided to separate the two in our asset allocation process. This is also aligned with growing interest we have seen among asset owners in EM ex-China allocations, given concerns about geopolitical and regulatory risk.
We are also often asked how we might group markets within EM ex-China into differentiated clusters. We ran a clustering analysis based on the return profiles of EM markets since 2010, and seven clear clusters emerged (Figure 2). Most had a regional footprint, but Turkey and Egypt had unique return profiles that did not naturally belong in any of the other clusters. The markets within each cluster had a correlation with each other that was higher than the correlations between the clusters overall. Also, the correlation between China and EM ex-China was lower than the average correlation between the clusters, adding to the case for separate China and EM ex-China allocations.
There are, of course, other ways to categorize markets within EM ex-China, including into exporters versus domestically oriented economies (as we discuss later) and by income cluster.
EM ex-China equities are relatively diversified, with the top three market weights — India, Taiwan and Korea — accounting for around 60% of the index (top chart, Figure 3), in contrast to EM as a whole, where China comprises 31% of the index. In terms of the regional breakdown of the EM ex-China index, Asia accounts for 84%, Latin America 13% and EMEA 3%.
Sector-wise, removing China from the investment universe leaves an EM ex-China index that is fairly concentrated in financials and information technology (around 50% of the index), at the expense of lower weights in consumer discretionary and telecoms (bottom chart, Figure 3). Commodity sectors make up only 18% of the index, but that is roughly double these sectors’ weights in DM indices. Outside of financials, sectors more likely to benefit from domestic economic development, such as health care and consumer services, are not well represented in EM ex-China indices. Therefore, the performance of index-based EM ex-China strategies may be tied more closely to the global and DM economic cycle than to EM growth drivers. This has implications for how investors should manage EM ex-China allocations in their portfolios, especially when portfolio diversification is directly impacted by EM ex-China’s higher correlation to DM allocations. Finally, as shown in Figure 4, EM ex-China is less concentrated in the 10 largest stocks, which isn’t a surprise given the larger size and greater breadth of the market versus China.
EM ex-China and China have historically traded at similar valuations on average (top chart, Figure 5), but this is a tale of two halves, with EM ex-China’s discount in the 10 years from 2004 flipping to a premium over China’s valuation in the subsequent 10 years. Both traded at substantial discounts to DM over this period, though this masked wide dispersions across certain markets.
The low valuations on Chinese equities reflect weaker profitability. Margins in China stand at 5% or roughly half that of EM ex-China (bottom chart, Figure 5). While EM ex-China presents a mixed profitability picture (margins in the five largest markets range from 6% to 22%), it has a significant edge over China. This reflects differences in sector composition, but also factors such as cross-sector governance and market structure (e.g., higher state ownership in China, which dilutes the focus on profitability). We’d also note that with EM ex-China, forward valuations have been at a relatively modest premium to China’s when taking into account forward profit margins, which have been much higher on average.
We took a closer look at the drivers of margins in EM to understand what accounts for these differences. While part of the draw of EM is higher economic growth, studies have shown that not all markets have historically been able to translate nominal economic growth into earnings (particularly EPS) growth, and even fewer have been able to transform economic growth into higher equity returns. Figure 6 shows GDP growth (both real and nominal), EPS growth and total returns in nominal terms in key markets. While the results vary significantly, one aspect that stands out is that large markets in EM ex-China fared better than China in terms of the link between economic growth and earnings growth. Most surprisingly, large markets in Latin America, such as Brazil and Mexico, generated EPS growth and total returns far in excess of the growth rates of their underlying economies.
We see three key reasons for the disconnect between EM economic growth and financial results:
Our research has also shown that more holistic measures of economic development, such as industry diversity and governance, have a stronger link to equity returns than economic growth.
Over the 20+ year period shown in Figure 8, EM ex-China has offered marginally lower returns and lower volatility than DM, which may be surprising to many investors (although EM ex-China offered higher returns than DM in the pre-GFC portion of this period). EM broadly was more volatile than DM, on average, driven by China.
On a forward-looking basis, we expect EM ex-China to be the best-performing equity region over the next decade (Figure 9). We expect EM ex-China to have significantly lower risk than China, but higher correlation to DM. In terms of the assumed drivers of higher returns in EM ex-China relative to China, they include lower dilution and higher dividend yields in the former. We expect China to continue to be weighed down by 4% – 6% annual dilution over the next decade (see “Important disclosure” section at the end of this paper for more on our capital market assumptions).
In summary, we think investors should consider breaking out EM ex-China from China in their EM allocations. In our view, EM ex-China offers higher return potential with significantly lower risk than China, as well as a superior translation of GDP growth to earnings and return. However, there are biases to keep in mind with an EM ex-China allocation, including sector concentrations and high revenue exposure to developed markets. In terms of implementation, while there are not currently many vehicles available to allocate separately to EM ex-China, these are fast emerging, driven by strong demand.
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Equities
General — Assumed market returns are based on the Investment Strategy Group’s expectations for future dividend yield, earnings growth, and valuation change. Assumed risk and correlations are based on historical analysis of the representative indices.
Indices used are as follows:
Developed market equity: MSCI World
Emerging market equity: MSCI Emerging Markets
China equity: MSCI China
EM ex-China equity: MSCI EM ex-China
Currencies
Return assumptions are shown for unhedged currency exposure, unless stated otherwise.
Hedged — Hedged currency return assumptions are based on current and forward-looking estimates for interest-rate differentials.
Unhedged — Unhedged currency return assumptions are formulated based on forward-looking estimates of real carry returns, normalization of real exchange rates, and an adjustment for productivity growth.
General
Period — Intermediate capital market assumptions reflect a long-term time period of approximately 10 years. If we developed expectations for different time periods, results shown would differ, perhaps significantly. Additionally, assumed annualized performance and results shown do not represent assumed performance for shorter periods (such as the one-year period) within the 10-year period, nor do they reflect our views of what we think may happen in other time periods besides the 10-year period. The annualized return represents our cumulative 10-year performance expectations annualized. The assumed returns shown do not reflect the potential for fluctuations and periods of negative performance.
This analysis is provided for illustrative purposes only. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies, or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve. This material relies on assumptions that are based on historical performance and our expectations of the future. These return assumptions are forward-looking, hypothetical, and are not representative of any actual portfolio, or the results that an actual portfolio may achieve. Note that asset-class assumptions are market or beta only (i.e., they ignore the impact of active management, transaction costs, management fees, etc.).
The expectations of future outcomes are based on subjective inputs (i.e., strategist/analyst judgment) and are subject to change without notice. As such, this analysis is subject to numerous limitations and biases and the use of alternative assumptions would yield different results. Expected return estimates are subject to uncertainty and error. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions. ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and used for illustrative purposes only. Investments cannot be made directly into an index.
This illustration does not consider transaction costs, management fees, or other expenses. It also does not consider liquidity (unless otherwise stated), or the impact associated with actual trading. These elements, among others, associated with actual investing would impact the assumed returns and risks, and results would likely be lower (returns) and higher (risk).
Any third-party data utilized in the analysis is believed to be reliable, but no assurance is being provided as to its accuracy or completeness.
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