As global equity markets continue their volatile trajectory, investors are seeking new avenues for portfolio diversification and returns.

One area that presents an intriguing contrarian opportunity is Chinese equities.

While sentiment around Chinese stocks remains bearish, the market's relatively low valuations and China's economic resurgence post-COVID make a compelling case for adding exposure.

With the S&P 500 reaching high valuations, the comparatively undervalued prices of Chinese stocks present an attractive entry point.

In this note, we will explore both direct and indirect investment avenues, evaluate associated risks, and discuss strategic considerations for leveraging these opportunities to their fullest potential.

The Valuation Appeal of Chinese Equities

Investing in Chinese equities now represents a strategic contrarian move, particularly when one considers the stark valuation disparities between Chinese stocks and their counterparts in the U.S. market.

The S&P 500, often seen as a barometer for U.S. equities, currently boasts high valuations that leave little room for upside, with a Price-to-earnings (P/E) ratio significantly higher than historical averages.

In contrast, major Chinese indices and the stocks they encompass feature markedly lower P/E ratios.

For example, the iShares MSCI China ETF (MCHI), a popular choice among investors seeking Chinese exposure, displays an average P/E of around 14, underscoring the undervaluation compared to the S&P 500's P/E of approximately 26.

The same story holds when looking at price-to-book metrics.

The yield on the MSCI China index is also higher than that of the S&P 500.

On the downside, Chinese stocks have significantly underperformed US stocks with higher volatility as well. Over the last three years, the MSCI China index is down 18% (annualized) while the S&P 500 is up 8%. To call Chinese stocks anything but a contrarian bet would be disingenuous.

Comparing the Economic Landscapes of the U.S. and China

The United States and China are the two largest economies in the world, each with unique strengths and challenges. The U.S. economy, characterized by its advanced technology, strong intellectual property laws, and dominant service sector, has shown resilience and adaptability. However, it faces challenges such as high inflation rates and potential overvaluations in several asset classes.

Conversely, China has emerged as a global manufacturing hub with significant government investment in technology and infrastructure. Although it has faced economic slowdowns due to trade disputes and the COVID-19 pandemic, China's economy is notable for its rapid growth rates compared to mature economies like the U.S. This growth is spurred by both state-led investments and an expanding consumer market.

For 2024 the IMF estimates that the Chinese economy will grow by 4.6% followed in 2025 by a 4.1% rate of GDP growth. In comparison, the US is expected to grow 2,4% in 2024 and 1.9% in 2025. China and the US have a symbiotic relationship with both economies propelling global growth.

While China and the US are both expected to grow their economies, the two economies don’t always move in sync with each other. Bridgewater Associates recently released a study titled “Where Can Investors Find Geographic Diversification Today?” that examines the economic linkages among major global economies. They conclude that China is the economy providing the most diversification to the US economy.

China moves to a different beat than the US. 

The Bridgewater report further states “Chinese assets are extremely diversifying because China has a relatively closed economy and is one of the largest demand centers in the world, leading to largely independent conditions and economic policy.”

Regulatory and Political Environments

The regulatory environment in the U.S. is stable and transparent, which provides a conducive atmosphere for business operations and investment. However, it also means that most high-growth opportunities might already be priced in.

China’s regulatory framework, while less predictable, can offer rapid adjustments that may favor entire sectors or industries, creating significant investment openings.

The political landscape also plays a critical role. While the U.S. benefits from a long-established legal framework and stable governance, China's political system allows for quicker decision-making, which can be a double-edged sword for investors. Swift policy changes can either boost or disrupt markets.

Direct vs. Indirect Exposure to Chinese Markets

For investors looking to capitalize directly on the opportunities within the Chinese equity market, several ETFs provide focused access to large-cap Chinese stocks.

The iShares China Large-Cap ETF (FXI), for example, targets the top Chinese companies, offering exposure to sectors that are pivotal in driving China’s economic engine.

Similarly, the MSCI China ETF (MCHI) and the SPDR S&P China ETF (GXC) provide broader exposure to a range of companies, from established giants to emerging players across various industries.

These funds have demonstrated considerable growth, especially in the technology and consumer sectors, reflecting the dynamic expansion of China's market landscape.

For purposes of attaining direct exposure to the Chinese stock market, we recommend the following funds:

• iShares MSCI China ETF (MCHI – 0.59%)

• iShares China Large-Cap ETF (FXI – 0.74%)

• SPDR® S&P China ETF (GXC – 0.59%)

Given that Chinese stocks represent close to 30% of the weight in emerging market indices another way to attain exposure is via broad-based emerging market funds. The two ETFs that we recommend are:

• iShares Core MSCI Emerging Markets (IEMG – 0.09%)

• Vanguard FTSE Emerging Markets ETF (VWO – 0.08%)

The tickers and net expense ratios are shown in brackets.

Performance Differences:

For most investors, particularly those with a conservative risk profile, indirect exposure through emerging market ETFs might be a more suitable strategy.

ETFs like the iShares MSCI Emerging Markets ETF (EEM), Vanguard FTSE Emerging Markets ETF (VWO), and iShares Core MSCI Emerging Markets ETF (IEMG) include significant allocations to Chinese equities while also providing diversification across other emerging markets like India, Brazil, and South Africa.

This diversification helps mitigate the risks associated with the concentration in a single country's market and offers a buffer during periods of volatility in Chinese stocks.

Funds exclusively invested in Chinese Stocks have significantly underperformed Emerging Market indices. For example, in 2023 both IEMG and VWO were up while outperforming the Chinese-focused ETFs by close to 20%. There have been years such as 2019 when the opposite was true.

The point is that single-country funds are much riskier than diversified broad indices.

Economic Sector and Style Differences:

Investing in China country funds compared to broad-based Emerging Market indices results in some style and sector variances.

Based on Morningstar’s style classification methodology, the FXI and GDX reside in the large-cap value category while the other fund alternatives exhibit core characteristics.

Similarly, in terms of sector composition the Chinese country funds are much more heavily allocated to consumer and communication services and commensurately much less exposed to technology stocks.

Strategic Considerations for Investors

Investing directly in Chinese equities, while potentially lucrative, carries its own set of risks that must be carefully considered.

The primary concerns include market volatility and the impact of regulatory changes, which can be abrupt and significantly affect market dynamics.

For example, regulatory crackdowns in sectors like technology and education have previously led to substantial market selloffs, underscoring the unpredictable nature of this investment landscape.

Chinese stocks are, however, excellent portfolio risk diversifers for US investors. The correlation of Chinese stock indices with the S&P 500 is currently in the neighborhood of 0.6. That is low for equity indices. In comparison, the correlation of US large and small-cap equities is usually north of 0.9.

Given the complexities and inherent risks of direct market exposure, indirect investment through emerging market ETFs emerges as a preferable option for the majority of individual investors.

This approach significantly reduces the risk by diversifying exposure not only across multiple companies within China but also across various countries within the emerging market segment.

Choosing the right mix between direct and indirect exposures to Chinese equities is crucial and depends largely on an investor’s risk tolerance, investment horizon, and the specific financial goals they aim to achieve.

• Investors with a higher risk tolerance and an interest in tapping into specific growth sectors within China might find direct investments more appealing.

• These investments, while riskier, offer the potential for higher returns by capitalizing on the specific dynamics and growth opportunities within the Chinese market.

• For those investors who are risk-averse, indirect exposure through broad-based emerging market ETFs might be the preferable route. This approach offers a more balanced exposure, minimizing the risks associated with the volatility of the Chinese market while still capitalizing on its growth potential.

• These ETFs also provide the added benefit of exposure to other emerging markets, which can help spread and manage risk more effectively.

The Big Picture:

• Equities keep outperforming bonds. The dominance of US large-cap equities has been a key driver of the outperformance over the last decade.

• The big losers last week were International Bond investors in particular those with heavy yen exposure.

• Currency has played a large role in the return profile of international bonds. As long as US interest rates carry a significant yield advantage the US dollar will remain strong.

• Real Estate investors topped the charts last week. This was a reversal from the prior week. Year to date the sector remains under attack, but offers interesting contrarian potential.

• Cash is again outperforming bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance. Our Risk Averion Inex (RAI) remains in the Exuberant Zone.

Economy:

• The US economy is expected to grow 2.7% this year, only slightly behind trend growth. Cracks are, however, emerging.

• Jobless claims hit the highest level since August. The number of people claiming unemployment benefits rose to 231,000. Likewise, continuing unemployment claims broke a four-week downward streak and rose to 1.79 million.

• Consumers are also feeling a bit less optimistic. The latest University of Michigan survey showed concerns regarding inflation, the unemployment picture, and the effect of higher interest rates.

• On a positive note, the much-feared recession has not materialized and the unemployment rate while trending higher remains below 4%.

Equities:

• US Large Cap equities narrowly outperformed last week. 

• Value outperformed growth last week as traditional value sectors such as Utilities, Financials, and Materials performed best.

• The best-performing style last week was Momentum. Year to date Momentum strategies are leading the pack with a 17.9% return.

• Utilities have been the surprise performer this year. Utilities within the S&P 500 (XLU) were up last week by over 4% and year-to-date are up 13.4%, best among all sectors. Most of that gain has occurred in the last month.

• International strategies have outperformed over the last month. 

• Emerging markets in particular have recovered in the last month. The resurgence of the Chinese equity market has much to do with that.

• European equities have been in a bull market rising due to favorable corporate reports and the expectation that the ECB will cut rates next month. For example, the UK’s FTSE 100 Index has reached a new record high.

• On the other hand, Japanese equities have been stalled in the near term as the market grapples with the uncertainty of central bank behavior.

• Will the Bank of Japan (BOJ) raise rates in the near term to defend the depreciating yen? A depreciating yen has been good for export-oriented companies and maybe the ride is ending.

Bonds:

• The Federal Reserve has shown zero willingness to lower rates unless inflation rates come down meaningfully. We’re a long g way from the 2% Fed target.

• Market participants got ahead of themselves with the expectation that rates would be cut earlier this year. The economy is too strong to warrant cuts at the moment and inflation has remained sticky.

• Long-maturity Treasury bonds gained last week as long-dated interest rates came down marginally while short rates stood firm.

• Year to date the performance of short-maturity bonds has trounced the return of long-maturity bond strategies. 

• The iShares 20+ Year Treasury Bond ETF (TLT) is down 7.6% for the year while the Treasury 1-3 Year Bond Index (SHY) is up 0.38%.

• The US Aggregate Bond Index, the best measure of the overall bond market, is down 1.97% for the year. Needless to say, this has been a tough year for bond investors.

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