Beyond China: what does the rest of the EM equity world have to offer?

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:

• The growing divergence in the behaviour of EM ex-China equities and Chinese equities
• The composition of the EM ex-China opportunity set (e.g., sector/market breakdown, concentration in top stocks, valuations)
• The link between economic growth and EPS growth and why it has proven to be stronger in EM ex-China
• The structural outlook for EM ex-China

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.

China and EM ex-China: the differences are becoming harder to ignore

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).

Figure 1

Figure 2

Figure 3

Figure 4

Figure 5

Figure 6

We see three key reasons for the disconnect between EM economic growth and financial results:

• Geographic sources of revenue — In EM ex-China, about 30% of revenues are derived from developed markets. Geographic exposure is therefore more diversified than in China, where over 90% of revenue comes from emerging markets (in large part, domestic). When investing in emerging markets, a key question is whether the selected markets are linked more closely to global growth (via exporters and commodities sectors) or to structural domestic change and dynamism.
• Role of the state — The larger role of the state in many major emerging markets and the weight of state-owned enterprises (SOEs) in the indices means that profit maximisation could play second fiddle to other policy priorities. That said, the share of SOEs has fallen significantly in most emerging markets over the past couple of decades, as part of larger reform drives.
• Equity dilution — In some emerging markets, including China and India, dilution driven by equity raisings and index rebalancing has been a significant drag on EPS, whereas net buybacks have tended to be additive to EPS growth in developed markets (Figure 7).

Figure 7

Figure 8

Figure 9

Important disclosure

MSCI data — Neither MSCI nor any other party involved in or related to compiling, computing, or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates, or any third party involved in or related to compiling, computing, or creating the data have any liability for any direct, indirect, special, punitive, consequential, or any other damages (including loss of profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’S express written consent.

Refinitiv data — Republication or redistribution of Refinitiv content, including by framing or similar means, is prohibited without the prior written consent of Refinitiv. Refinitiv is not liable for any errors or delays in Refinitiv content, or for any actions taken in reliance on such content. Refinitiv’s logo is a trademark of Refinitiv and its affiliated companies.

Important disclosures: capital market assumptions

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.

To read more, please click the download link below.