Over the past four years, China has made significant efforts to further open its capital markets, and in February, index provider MSCI announced its decision to increase the weighting and breadth of China A-shares exposure in its emerging markets index, as well as in its China index and other regional indices. The three-step implementation process will see the inclusion factor go from 5% to 20% in total by November 2019.
These increases are naturally of great interest to investors but to a large extent, merely scratch the surface of opportunity in the latest iteration of China’s growth story.
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China Small Caps: The World’s Growth Engine?
With the idea of a dedicated allocation to China receiving more and more consideration from institutional investors globally, many are drilling deeper into the type of exposure they have, going beyond adding China for its own sake and looking for more growth opportunities. As they look for differentiation with respect to their China holdings, China small entrepreneurial companies – which now constitute the world’s largest small cap market – are emerging as powerful engines of growth.
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Why a Dedicated Allocation to China Makes Sense
Capturing the growth of the world’s second-largest economy, China equities can serve as a core, strategic holding for long-term investors. Yet many investors remain under-allocated, despite China’s enormous economic output. China currently makes up roughly 33% of the MSCI Emerging Markets (EM) Index, so some investors may think they have adequate China exposure through their EM allocation. Investors often allocate less than 10% of an overall portfolio, however, to emerging markets. Against this backdrop, China may represent only 1% to 3% of a portfolio that is considered to be globally diversified. What’s more, many active EM managers are underweight China relative to the benchmark, so investors might have even less exposure to China than they intend. Given that the size of China’s economy could surpass that of the U.S. within a decade, many investors may need to increase their weight toward China to better align portfolios with long-term goals.
Where to Invest in China: New Sectors Drive Earnings Growth
The earnings story in China today is about changing market composition. The old industrials are becoming less important while the new industrials are taking on a bigger role from a macro perspective. As bottom-up, fundamental investors, at Matthews Asia, we see the emergence of sectors such as IT, pharmaceuticals and consumer discretionary. The composition change is important for the earnings turn, and we believe earnings are on more solid footing than in previous cycles. Earlier, we saw the earnings cycle in China as cyclical in nature – now, in part due to consumer spending, we are beginning to see less cyclicality in the cycle.
We believe a dedicated allocation to China can help investors fine-tune and recalibrate how they gain access to the world’s fastest-growing economy, while improving global diversification. As a core portfolio holding, China equities can comfortably sit alongside such portfolio staples as U.S. and EAFE (Europe, Australasia and the Far East) investment strategies. Looking ahead, we expect earnings growth in China to be increasingly driven by innovation and consumer-driven sectors. As the spending power of China’s middle class continues to grow, sectors and industries such as health care, travel and leisure, and consumer services will play a much greater role in fueling China’s economic engine. Accordingly, we believe that an effective way to capture the future of China’s growth is through a dedicated allocation to China that employs an active approach to security selection. Given China’s growth potential, investors may benefit from considering China strategies that are forward-looking by design, seeking to capture China’s future, rather than its past.
Where to Invest in China: New Sectors Drive Earnings Growth
The earnings story in China today is about changing market composition. The old industrials are becoming less important while the new industrials are taking on a bigger role from a macro perspective. As bottom-up, fundamental investors, at Matthews Asia, we see the emergence of sectors such as IT, pharmaceuticals and consumer discretionary. The composition change is important for the earnings turn, and we believe earnings are on more solid footing than in previous cycles. Earlier, we saw the earnings cycle in China as cyclical in nature – now, in part due to consumer spending, we are beginning to see less cyclicality in the cycle.
We believe a dedicated allocation to China can help investors fine-tune and recalibrate how they gain access to the world’s fastest-growing economy, while improving global diversification. As a core portfolio holding, China equities can comfortably sit alongside such portfolio staples as U.S. and EAFE (Europe, Australasia and the Far East) investment strategies. Looking ahead, we expect earnings growth in China to be increasingly driven by innovation and consumer-driven sectors. As the spending power of China’s middle class continues to grow, sectors and industries such as health care, travel and leisure, and consumer services will play a much greater role in fueling China’s economic engine. Accordingly, we believe that an effective way to capture the future of China’s growth is through a dedicated allocation to China that employs an active approach to security selection. Given China’s growth potential, investors may benefit from considering China strategies that are forward-looking by design, seeking to capture China’s future, rather than its past.
