A standalone strategy: investors are likely to separate China from broader emerging markets

Interview reprinted from Asia Asset Management August 2021
More and more asset owners are expected to separate out China from their emerging-markets portfolio in order to better capture investment opportunities arising from the strong growth of the country’s consumption sector.
Mike Shiao, Chief Investment Officer for Asia ex-Japan at Invesco, shares his views on the significance of a standalone strategy for China, as well as global investment trends, in this written interview with Asia Asset Management.
What are the major tail risks in the global and Asian markets? How do Asian asset owners rebalance their portfolios in current market conditions?
Potential tail risks that we are watching are the [coronavirus] pandemic and geopolitical tensions. The containment of coronavirus globally and vaccine rollout is a key factor driving global markets, and we are monitoring the progress closely. Meanwhile, we believe that US-China tension will be an ongoing topic. That said, we don’t expect this tension to derail China’s long-term economic progression.
We focus on domestic opportunities in China. We continue to position in structural growth sectors including consumer, internet and healthcare, and we believe the investment cases for those areas remain intact.
China is repositioning its growth drivers towards consumption and services, which are already the largest contributors to gross domestic product growth. We expect its consumption market to double its current size by 2030 to reach US$17 trillion, supported by an expanding middle class and sustained income growth. As such, we stay focused on areas that can benefit from structural growth drivers in China, including consumer, internet, and healthcare.
Rebalancing flows is ongoing given the change in weighting of Asian equities in the MSCI Emerging Market Index. The most notable changes would be in China A-shares as its inclusion factor in the MSCI index is rising (currently 20%) over time.
Going forward, we believe that fund flows will increase as investors catch up with their allocation in Asian and Chinese equities given their current light positioning.
How do you expect investors to adjust their strategic asset allocation for China?
Most investors are investing now via emerging-market exposures. We believe this doesn’t give investors sufficient exposure to China given China’s economic rise, strong risk-adjusted returns, and unique opportunities. We feel more strongly than ever that investors should implement a standalone China allocation. We have an increasing number of discussions with investors who started to do so over time.
There are several reasons for investors to set up a dedicated China allocation:
• China is an exceptional emerging market
The Chinese economy is now larger than the GDP of India, Russia, Africa, and Latin America combined, and we believe it will continue to deliver premium growth going forward. We believe the Chinese economy is poised for long-term structural growth, and the current strength we see from a broad range of economic indicators will continue. Meanwhile, its equity market is the second largest in the world, well ahead of the third largest, Japan, that is only around 40% of China’s size. Japan is already treated as a distinct asset class.
• Appealing risk-adjusted returns
The strong positive economic prospects of China has been reflected in its equity market performance. We compared the return and risk profile of Chinese equities and emerging markets ex-China equities on a five-year basis. Chinese equities delivered a much higher annualised return, and even after adjusting for risk, they still offer a premium over emerging markets ex-China equities.
• Unique domestic opportunities
The emergence of the Chinese economy has given rise to abundant competitive Chinese enterprises in a broad range of sectors. There are now more than 5,500 Chinese companies that are listed across Mainland China, Hong Kong and the US. We believe they provide a large selection of alpha sources for investors to choose from when constructing their portfolios.
Environmental, social and governance development in China is an area that some investors are concerned about. In China, a key challenge is the lack of adequate ESG information on its companies, which lag disclosure requirements of Western peers.
How can institutional investors capitalise on Asia Pacific’s economic recovery from the pandemic?
We believe Asian economies are on the positive trend to return to their pre-Covid growth path. Vaccination is accelerating in many parts of the region, boding well for continued activity normalisation.
Meanwhile, strong economic recovery in the US and other developed markets will help accelerate growth in Asia thanks to the linkage via the exports sector. In particular, the Covid-19 crisis has strengthened China’s economic leadership. China has managed to emerge strongly from the Covid-19 crisis thanks to effective containment, and we expect its GDP growth [to be] higher than the global average.
We believe Asian consumer demand represents one of the most exciting consumer stories in investment history. Supported by a large population base and fast economic growth, Asia’s consumer economy is simply massive. It has more than half of the world’s total middle class and is the world’s largest retail market. It is well documented that both of these are poised for further expansion.
At the heart of this, we see five mega trends propelling this sustained consumption growth in Asia – digitalisation, ‘premiumisation’, experience, urbanisation and wellness. Each of these trends is unique and structural and reflects the driving forces behind this growth.
Despite disruptions caused by the ongoing pandemic, we believe these trends remain intact, with some even being accelerated during this challenging period. For example, our transition to an online lifestyle (digitalisation) and our increasing awareness of personal health issues (wellness).
How does Invesco help institutional clients incorporate ESG in their investment process?
ESG aspects can have an impact on sustainable value creation and risk exposures, and companies with ESG potential may present investment opportunities. Our investment team is in a unique position to encourage change and have an impact through its engagement and dialogue with invested companies. We believe it brings value to our clients by adopting and implementing ESG principles.
Having a solid research process is key. Taking our team as an example: apart from using external resources, we also conduct our own internal proprietary ESG research. We utilise external information obtained from company disclosures, third-party ESG rating and research, Invesco’s own proprietary ESG Intel Rating and company engagement in our in-depth ESG analysis. We evaluate our findings using a mix of qualitative and quantitative factors, leading to a five-tiered risk rating that reflects our views on ESG impacts.
As part of our investment process, portfolio managers and research analysts are required to explicitly state whether fair value will be adjusted from an ESG perspective. In the long term, we believe continuous active engagement and execution of proxy votes can help manage, protect and enhance the value of our clients’ investments.
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