Commentary: Why an emerging markets ex-China strategy offers a new opportunity set

The emerging markets equity landscape has changed materially both in size and shape. The market capitalization of companies across emerging markets has been morphing, changing, rotating, but with one consistent theme — that of the growing dominance of Chinese equities. China comprises more than 30% of the MSCI Emerging Markets index and continues to grow in scale, importance and consequence. But even with this increasing dominance within emerging markets, it can be argued that China is still underrepresented within global investment markets and investor portfolios and justifies a larger allocation as depicted in Figure 1.

When investors think about allocations to emerging markets, they often do so to capture the diverse return opportunities over time, of which China has now become the primary driver. The largest stocks in the MSCI Emerging Markets index have also become more Chinese-centric. As a single country becomes dominant in an equity index, investors tend to move to discrete allocations to that country. This creates demand for a new regional construct to ensure the investment opportunity set does not shrink.

Where single countries dominate, such as the U.S. in the MSCI World index, investors have made discrete allocations to that market which has supported the growing popularity of the World ex-USA Index and the MSCI EAFE, or Europe, Australasia and Far East index. We believe that China and the MSCI Emerging Markets index may follow a similar path. We also note that China's market capitalization is now well above levels of Japan 10 years ago, a market which has long had discrete allocations.

China represented just 5% of the MSCI Emerging Markets index 20 years ago. As of Dec. 31, 2021, it stood at 32% and is forecast to rise to 44% in the next few years based on a 100% inclusion of China A shares into the index.

China's rising share of the index has come at the expense of other emerging markets. As China's index weight continues to increase, it can crowd out attractive alpha opportunities. There remains a huge number of idiosyncratic opportunities across emerging markets ex-China which justify a separate market allocation. For example, relatively recent additions to the index such as Saudi Arabia, the United Arab Emirates, Qatar and Kuwait have somewhat been lost in the growing dominance of China.

Likewise, there are many potential investment opportunities from smaller emerging markets countries that often fly under the radar. We still see a growing number of candidates outside of China that offer investment opportunities.

South Africa was almost 15% of the MSCI Emerging Markets index in 2002. In 2015, the weight dropped to 6.8%. Today, its share has fallen to 3.2%. Similarly, other markets such as Mexico, Malaysia, Chile, etc., have experienced similar diminishing shares. What this means is that there is the risk of missing out on the attractive valuation opportunities these markets offer (see Figure 2) .

Based on price-to-book ratios over the last 10 years, markets such as Indonesia, Malaysia, Philippines, Mexico, South Africa, Turkey and Chile are trading at very attractive levels. At current valuations, these markets will likely offer plenty of investment options.

Valuations aside, there are some other notable differences when we compare metrics between the MSCI Emerging Markets index and the MSCI Emerging Markets ex-China index. First, the stock count has dropped from 1,157 to 662 in emerging markets-ex China which reflects the long tail of the smaller companies in the Chinese A share market, but still offers a large universe for a bottom-up stock picker.

As to China specifically, while the investment opportunity remains attractive, ongoing U.S.-China tensions and pressure from the West about China's stance on the Russia-Ukraine conflict may continue to impact Chinese equities. Companies and governments are already diversifying their supply chains to reduce reliance on China.

Meanwhile China's domestic policy initiatives have hurt several sectors' share prices. All these factors can complicate investment decisions regarding Chinese equities. As such, an emerging markets ex-China allocation can help clients to navigate any such issues.

Chinese equities' dominance is evident in global equity fund flows' data. Data from 2017 show that there has been a steady rise of cumulative net inflows into China-A share equities. Conversely, emerging markets ex-China experienced a steady decline; net outflows amounted to $100 billion as of Dec. 31, 2021. As a result, emerging markets ex-China's allocation in global mutual funds is well below the historic average.

Despite the outflows, emerging markets ex-China's investible universe has exhibited comparable liquidity to other major markets. Aside from the U.S., the average six month liquidity based on value traded in emerging markets ex-China for stocks with more than a $2 billion market cap is on par with the European Union ex-U.K.

Post-2008 global financial crisis, the policy response from central banks and governments then focused on monetary policy and the banking system. There was little growth, no inflation, a bias away from capital expenditures and asset-heavy models. This was the decade of the digital revolution; investors avoided value names and instead preferred high-quality stocks and those with short-term earnings potential. This trend was exacerbated in 2020 due to COVID-19 and created an extreme valuation dispersion within emerging markets ex-China between cheap stocks and expensive stocks.

But since late 2020, there has been a reversal in sentiment with value stocks strongly outperforming their growth sector peers. Despite the outperformance, there is still plenty of room for value stocks to continue their run given that the current policy response is focused on investing in the real economy and supporting consumers. We are seeing substantial inflationary pressure along with rising rates which can help value stocks while hurting expensive growth and quality stocks.

We also believe this is the decade of the decarbonization revolution which will benefit equities related to real economy sectors such as many of those in the value space. A value-driven emerging markets ex-China strategy also tends to outperform in the long term (see Figure 3). Disciplined value investors thus have a unique opportunity to capture future outperformance in a diversified emerging markets ex-China universe.

Navin Hingorani is a portfolio manager at Eastspring Investments, based in Singapore. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.