The New York Times recently published an article on the dismal performance of the Chinese stock market that had an interesting twist. According to the article, Chinese investors have become so disillusioned with their domestic market that they’re increasingly putting their money into ETFs tracking foreign stock markets.
“Putting money in stocks is inherently risky,” the article says. “But Chinese investors are experiencing something especially alarming: financial losses in the markets, declining home values and a government that doesn’t want any public discussion of what’s happening.”
News that Chinese investors are fleeing their own market may give you pause if you’re invested in an emerging markets fund that includes a large weighting in Chinese stocks. Chinese equities are the largest component of the MSCI Emerging Markets Index with a weighting of just less than 25%.
Last year was generally a good one for stock markets around the world, but China was a notable exception. It fell 11.0% in U.S. dollar terms and the losses have continued this year. This poor performance came on top of declines of over 21% in both 2021 and 2022.
However, most worrisome for many investors is the government’s bellicose attitude towards Taiwan. Taiwan makes up 22.6% of the MSCI Emerging Markets Index. Obviously, if China’s sabre-rattling toward Taiwan turns into outright military conflict, it would be very bad for emerging markets portfolios.
So, how should a Canadian investor look at emerging markets? The first thing to remember is that good investing requires managing risks, not avoiding them. Indeed, you must take risk to earn returns. Once you accept this basic truth, the questions become: Which risks will you take and how much?
When it comes to emerging markets, it’s useful to consider China’s place in your overall portfolio mix. For our clients, Chinese equities make up 2% to 4% of assets, a reasonable level of risk. Next, rather than focusing on any one market, you should consider the merits of investing in emerging markets as a whole.
When we look beyond the Chinese slice of the emerging market pie, we find some of the world’s fastest growing economies, including India (18.0% of the MSCI index), South Korea (12.2%) and Brazil (5.7%).
Owning these other emerging markets gives you exposure to such important global companies as Taiwan Semiconductor Manufacturing, the world’s largest and most sophisticated producer of microchips, Korea’s Samsung Electronics and India’s Tata conglomerate.
The performance of the various emerging markets in 2023 demonstrated the diversification value of holding these other countries. In contrast to the 11% drop for the Chinese market in U.S. dollars, the Taiwan market rose by 31.3%, India by 22.0%, South Korea by 23.6% and Brazil by 32.7%.
As a result, the emerging markets index was ahead by 7.9% in 2023 in Canadian dollars. Admittedly that was the worst performance among the geographic equity classes, led by the U.S. (+23.3%), developed international equity (+15.7%) and Canada (+11.8%). And emerging markets underperformance wasn’t a one-year phenomenon. They’ve been underperforming the other major equity regions for the last decade.
But let’s look back further to the decade ending in 2010. Back then, emerging markets outpaced the others, generating an annual +11.6% return in the decade compared to +6.6% for Canada, -2.1% for the U.S. and -2.6% for the developed markets.
Which brings us back to China. Once you’ve tallied up all the things going wrong in China, save a thought for what might actually go right in the coming months and years. For example, cooling tensions with Taiwan or good news on the economic front could send Chinese stocks much higher than expected today.
Basing your investment decisions on what happened in the rearview mirror is what leads to buy high, sell low behaviour. The best approach is always to opt for diversification and patience. In that context, we believe a prudent allocation to emerging markets equities should remain a part of a broadly diversified portfolio.