Emerging market equities expert says historical trends and underweighted index positions point to latent long-term potential
While Chinese equities may have seen significant challenges over the past year, they could represent a good long-term play for global investors seeking emerging-market diversification amid today’s turbulent financial world, according to one equities specialist.
“If you look at the top quintile of companies in terms of profitability and return on investment globally, around 15% of those are Chinese. These companies are very profitable, they’re very international, and they're also growing fast,” said Anthony Corrigan, Client Portfolio Manager for mtx strategies at Vontobel Asset Management. “Around 35% of the MSCI ACWI index with three year rolling sales growth of greater than 10% are also Chinese.”
According to Corrigan, China’s share of global market capitalization is lower than its share of global GDP. And while Chinese onshore companies aren’t currently fully replicated into global indices, Vontobel’s mtx team anticipates this could happen by 2026. That would mean China’s weight in the MSCI Emerging Markets Index could grow from currently around 32% to more than 40%.
Beyond that, the correlation of Chinese equities’ performance to that of global equities is very low – around 30% for U.S. equities, and slightly higher for emerging-market equities – which makes for good diversification within a global portfolio. Beyond that, he points to the extreme volatility in China’s onshore equity market, which creates huge mispricing that favours active managers looking for stocks at bargain valuations.
“That's something we have loved to do within our portfolio. We love to try and find names that have been struggling because of issues other than their fundamentals, and we add them into the portfolio if it's the right thing to do,” Corrigan says. “We're very confident on China over the medium-to-longer term.
Still, there are near-term headaches and headwinds. China’s COVID policy has been a point of concern and scrutiny, and Vontobel doesn’t anticipate any drastic changes to that until after the 20th National Congress of the Chinese Communist Party, which is anticipated to see Xi Jinping being confirmed for another term. But to prevent social unrest among its citizens, the country has to get a handle on the virus and eventually find a way to live with it.
A comeback for emerging markets?
More broadly, Corrigan says investors should consider the long-term opportunity in emerging market equities. Looking at historical trends in the Shiller PE ratio, which takes earnings adjusted for inflation and otherwise known as the cyclically adjusted price-to-earnings ratio, he says EM equities were trading at a substantial premium to developed-market equities during the 2000s. That was spurred by the commodity supercycle driven by China’s ambitious push to become a global force.
“Since then, that premium has completely dissipated,” Corrigan says. “Now emerging markets trade at a discount to developed markets of around 40%.”
A global investor looking at their portfolio today might be disappointed by their EM stock positions’ performance right now. But while the Shiller PE is not a very good leading indicator of short-term market moves, Corrigan says it has a strong explanatory power for longer-term returns across 5- to 10-year periods, which means overweighting to emerging markets can make total sense for investors who can afford to play the long game.
He also notes that compared to their average EM allocations observed historically, global investors’ current allocations are much lower. If allocations start to revert to the historical mean, flows into EM could start to come in more rapidly than they have been in the recent past.
Corrigan encourages those looking to allocate more toward EMs to think carefully about their style exposure as well. Since the end of COVID, he said lower-quality stocks have performed very well within emerging markets – but that trend could be reversing.
“Because we're in a lower-growth environment, I think investors are going to start focusing on the fundamentals of a company. They’ll start looking for companies that can be profitable, and companies that can grow sustainably,” Corrigan says. “I think that that will herald a shift in rotation and style where quality might start to outperform again.”