Merits for a dedicated China allocation

The economic success of China presents appealing investment opportunities in a broad range of sectors; and continued reforms and liberalization efforts have enabled much easier access to its financial markets. 

A top question is how investors can gain exposure to China. Most international investors are gaining exposures now via a multi-country portfolio or index. We believe this doesn’t give investors the sufficient exposures to China given China’s economic rise, strong risk-adjusted returns (see Table 1), and unique opportunities. Our view is that investors can consider implementing a standalone China allocation.

China is an exceptional emerging market

We believe China deserves a separate allocation despite being classified as an emerging market by index providers. 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. 

China’s 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. In particular, the COVID-19 crisis has strengthened China’s economic leadership (Chart1). China has managed to emerge strongly from the COVID-19 crisis thanks to effective containment. Real GDP expanded +2.3% year-on-year in 2020, being the only major economy globally that delivered positive growth. Economic activities were strong entering 2021, benefiting from continued recovery in both domestic and external demand. This contrasts with other parts of emerging markets whose outlooks remain clouded by uncertainties surrounding the pandemic. 

We believe the Chinese economy is poised for long-term structural growth, and the current strengths we see from a broad range of economic indicators will continue. China is repositioning its growth drivers towards consumption and services which are already the largest contributors to GDP 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. Policy support is expected to be strong given consumption’s strategic importance to the government’s long-term growth plan. These can enable China to generate sustained expansion going forward and to remain the largest driver of global growth. 

Historic appealing risk-adjusted returns

The strong positive economic prospects of China have been reflected in its equity market performance (Chart 2). 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 annualized return, and even after adjusting for risk, they have offered a premium over Emerging Markets ex-China equities (Table 1).

Position into the future 

From an index perspective, China’s importance in the MSCI EM index has risen in recent years. Its index weight has increased to around 40% now from below 25% five years ago. We expect its index weight to keep rising given faster economic growth and further A share inclusion. We have seen the return correlation between China and Emerging Markets structurally rising to around 0.9 from 0.6 over the past 20 years (Chart 3). We believe emerging market equities can become almost indistinguishable from China alone once China’s weight exceeds a certain threshold.

It then may be worth considering having a separate China allocation that can fully capture the entire opportunity set in China. A dedicated China allocation can allow investors to tap into names that are yet known by investors, helping to uncover more alpha sources. 

Unique domestic opportunities
The growth 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. 

When comparing with other emerging markets, the communication services, consumer discretionary and healthcare sectors together account for above 60% of the MSCI China Index while only comprising 17% of the MSCI EM ex-China index (Chart 4). Other emerging markets remain dominated by traditional growth sectors such as financials and materials (except for Taiwan and Korea that are dominated by information technology sector). We believe the difference in sector composition is another reason for having a dedicated China allocation. It provides investors with opportunities to position for the future, particularly as COVID-19 is structurally changing our living and working habits.

What could be some pushbacks to our views?
Pushback 1: COVID-19 will have long-lasting impact on employment and income growth in China
As consumption is gaining importance in driving China’s economic growth, many international investors are concerned about whether China can generate enough employment and income growth to support continued strength in domestic consumption. We think it is a valid point, particularly considering the COVID-19 situation. 

Indeed, the government’s surveyed unemployment rate rose to +6.2% in February last year and urban households only saw an increase of +0.5% in their disposal income in the first quarter. These data points are however improving as the economy recovers. Unemployment rate fell to +5.1% in April this year. On the income side, growth also picked up to +12.2% in the first quarter of 2021.¹ We expect further improvement in 2021 as economic activities are on track for normalization. 

From a long-term perspective, the government is placing a growing focus on the quality of growth rather than quantity. Employment is being given priority among various policy directions. We expect supportive policies to help stabilize and promote employment. Meanwhile, income inequality is on top of the policy makers’ agendas as well. China released its new Five-Year Plan this year and there is strong emphasis on social welfare and improving income equality in the document. 

Pushback 2: Geopolitical tensions with the US will derail its long-term growth
Our team believes the geopolitical tensions with the US will be an ongoing topic. This is in line with many investors’ views. That said, we don’t expect this tension to derail China’s long-term economic progression. 

Our view is that it is worth investing in China in spite of the ongoing tensions. China has a large and expanding domestic market, which is a valuable feature of its economy. This allows China to enjoy unique economic and business cycles that rely on its domestic strength, which will help to shield it from geopolitical complications. On the corporate level, Chinese companies derive over 90% of their revenues from the domestic market and less than 5% from the US.²   

Pushback 3: ESG standards are low in China
China pledged last year during the United Nations General Assembly that it will reach carbon neutrality by 2060. We believe such an ambitious commitment exemplifies China’s desire to pursue long-term sustainable growth and will propel the wave of ESG development going forward. ESG development is already gaining traction in China. We see an upward trend in disclosure rates of environmental, social and governance indicators that are gradually catching up with global and regional standards. 

Regulators are a powerful force in China. We expect strengthened regulations to drive further improvements in ESG disclosures among Chinese companies. The China Securities Regulatory Commission (CSRC) is expected to publish guidelines for mandatory corporate disclosure on ESG issues soon. In addition, we believe continued financial liberalization to attract more foreign investors will also drive ESG development in China. We believe the increased focus on ESG by international investors will lead to rising awareness and improvements in ESG practices.

Conclusion 
We believe a dedicated China allocation is what investors can consider. Besides having premium growth, the country may also offer the benefits of abundant attractive investment opportunities. Its investment universe is deep and diverse and may provide investors with ample compelling opportunities thriving from structural growth areas. 

We believe investors can consider adopting an all share approach while investing in Chinese equities. An all share approach means selecting opportunities irrespective of listing locations. We believe both onshore and offshore Chinese markets have unique listed companies and together they represent the complete opportunity set for investors. We believe investors can look to experienced managers to make the best stock selection choices.

About us
Our Asia Equity Investment Team based in multiple locations in Asia at Invesco manages a broad range of investment products that invest in Chinese equities on behalf of clients globally. Our strategies are actively looking for alpha opportunities and aiming to deliver sustainable returns over the long term. Our leading Portfolio Manager, Mike Shiao, has 29 industry experience and is considered as one of the top managers on Chinese equities. He is well supported by a team of 17 analysts with on average 18 years of experience. We are adopting a purely bottom-up stock selection process to identify companies with competitive advantage and sustainable leadership. It has led us to have a broad and diverse exposures to Chinese equities that may benefit from structural growth in China. We take ESG considerations seriously and historically have high ESG standards. Alongside other financial indicators, the evaluation of ESG factors is among inputs to the investment process, as part of fundamental research, company dialogue and portfolio monitoring. We prefer private enterprises from a corporate governance perspective and given a strong sense of entrepreneurship.

Investment Risks:
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.

1. National Bureau of Statistics. May 2021
2. Credit Suisse, FactSet, MSCI. June 2020 

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IM2021-035

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