Busting 3 Myths About China

Everyone seems excited about emerging markets this year, pouring money into EM ETFs as the segment offers investors attractive valuations and some fundamental improvement. But the largest of all emerging markets, China, remains possibly the most misunderstood.

When looking at single-country opportunities among emerging markets, investors of all types—be it retail or institutional—are still “skeptical at best, [filled with] horror at worst” when it comes to China. That’s the assessment of Tyler Mordy, president and CIO of Forstrong Global, and an assessment that a panel of emerging market experts hosted Friday by BlackRock shared.

“We’ve had several emerging market crises over the years, and if you look at the fundamental picture, chances of another crisis are relatively low compared to the West,” Mordy said. “But investors have a lot of scar tissue towards emerging markets, and specifically on China, there’s a lot of misinformation circulating.”

“The West continues to get the story wrong,” he added. “It continues to misread Beijing’s policy signals and misunderstand the Chinese economy.”

So what do investors get wrong about China?

Myth No. 1: The correlation between GDP growth, earnings growth and market performance

For the past few years, market pundits have been saying that China was headed to one place and one place alone: a crash landing. One of the key points they highlight is the slowdown in GDP growth in recent years, now around 6-7% a year, but a far cry from the double-digit days in the early 2000s.

Never has 7% annual GDP growth translated into such muted market gains.

The reality is that China’s economy and the market for Chinese equities—be it mainland or otherwise—has largely decoupled.

Post-global financial crisis, the relationship between GDP and equity market returns “broke down” because policymakers “hit the gas aggressively” with monetary loosening and economic stimulus, said Helen Zhu, head of China Equities at BlackRock. Over time, there has been a switch in the way U.S. investors interpret China growth, she said Friday.

In recent years, even though Chinese growth was still ample, there was growing concern that the quality and sustainability of that growth wasn’t there. Growth coming from massive investment and credit bubbles, and resulting in environmental pollution, social disparity and corruption, was not the type of growth investors were willing to pay up for anymore, Zhu noted.

“So, we’ve seen a decoupling between the growth (GDP and earnings have been growing) and the market (which didn’t go anywhere). Valuations kept coming down,” she said.

But that’s changing. “Now, people aren’t looking for blockbuster growth, but for more sustainable growth combined with the unwinding of some of the problems of previous years,” according to Zhu. It’s a process that’s still in its infancy.

Kate Moore, chief equity strategist at BlackRock, agreed.

“As we look at China, and the breakdown between consumption and investment, we need to break the narrative that there has to be high correlation between GDP and earnings. We’re seeing policy support, supply-side reform and secular growth,” she said.

Myth No. 2: It isn’t as simple as splitting China’s story into old economy vs. new economy

There are plenty of concerns about deleveraging and policy risk in China. Near-term tightening is inevitable, market bulls say. But China’s policymakers want to stay in the “sweet spot” where growth is good enough to implement reforms and address problems investors are concerned about, according to Zhu. The ongoing reflationary trend and the improvement in the global economy are all tail winds for China.

There have also been supply-side reforms in China: As Moore mentioned, growth, earnings and Chinese yields are all picking up, and many industries are starting to make money again and reinvest it. There’s plenty to be bullish about when it comes to that country.

“Short-term pain will be long-term gain,” Zhu said. “Over time, returns will come from valuations normalizing.”

But there’s still a prevailing view that investing in China is a choice between betting on the old economy or the new economy. If you look at the two largest China ETFs—the iShares China Large-Cap ETF (FXI) and the iShares MSCI China ETF (MCHI)—you see some of that dichotomy.

FXI, a large-cap fund, allocates some 50% to financials, 13% to energy and 11% to telecoms. MCHI, a total market fund, is nearly 33% into information technology, 33% into financials and 10% into consumer discretionary.

Year-to-date, their performances are dispersed: 

Chart courtesy of StockCharts.com

Historically, investors like to say they are bullish on Chinese consumption, Chinese internet and Chinese health care, because China is headed toward a consumption-based economy. These are the hot sectors that benefit from that focus. On the flip side are financials, and cyclicals—the so-called old economy that many see as “unsustainable.”

“But we can’t invest that way,” Zhu said.

First, because China, like any other emerging market, is a long-term story. And the only constant about China is that China is always changing.

And if everyone is thinking that new economy is the way to go, these ideas have already been priced into the market. Instead, focus on expectations and look for underappreciated, undervalued segments that could surprise on the upside, Zhu explained. Many of the reforms China’s new administration is pursuing could boost old-economy sectors longer term.

“You have to look at structural changes that are permanent. And winners and losers can be very different than that generalization of old economy/new economy that people have ascribed to China for a long time,” she added.

Myth No. 3: Nothing beats direct allocations to a single country; proxies only go so far

Many investors don’t have difficulty identifying the growth plot line in emerging markets, but they are quick to assume they can tap into that story through U.S.-based companies that do a lot of business in emerging market economies. Domestic bias is strong, and it also impacts international allocations.

There is also the instinct to link emerging market growth to commodities, opting to tap into that growth story via commodity strategies or via global companies with footprints in the regions instead.

This proxy-type access misses a lot of the domestic opportunities direct investment affords, Mordy said. Global companies compete with local ones, and they often don’t offer a direct vector into the potential growth and gains that are in these markets. Boots on the ground can deliver very different results.

According to him, the best way to tap into China is by going into the market itself through ETFs like FXI and MCHI. Nothing beats direct access.

Today investors can be as broadly diversified or as segment-specific as they like, with a lineup of 45 ETFs offering direct exposure to the world’s largest emerging market.

Contact Cinthia Murphy at [email protected]