Coming into its own

The case for a standalone allocation to China

13 Jun 2019 5 min read

China's impact on global markets was made clear earlier this year when its return to economic growth, along with the US Fed's policy turnaround, helped pull global markets out of a fourth-quarter downturn. China's continuing growth and its standing as the world's second largest economy support our experts' belief that the case for a standalone approach to China is growing increasingly compelling.

Read what our experts have to say

Hayden Briscoe
Head of Asia Pacific Fixed Income

When Bloomberg put China bonds into its indices in April 2019 it sent a big message to the world, namely that Chinese bonds went directly into a developed market benchmark. That's largely because of the size of the onshore bond market, which we believe will soon grow larger than Japan's, to become the second largest in the world. So purely from a sizing perspective it makes sense to think of an allocation to China in a standalone sense, just as investors look at focused  allocations to the US, UK, and Japan.

Moving away from size to returns, historically, China's bond markets have offered relatively high nominal and real yields versus developed markets. That's vital for investors to remember, particularly if global growth slows. The world is starved of bond markets that offer defensive characteristics, and China is one of the few defensive markets offering spread pick-up against US, German, Japanese, and UK yields.

Finally, when thinking of standalone allocations, investors need to think about where the world is going to be in five to ten years. In our view, that means preparing for an RMB currency bloc with a standalone allocation to China fixed income. China's clout in terms of trade and investment in the Asia-Pacific region should only continue  to grow, and we expect the RMB will move to reserve currency status, creating a RMB-bloc, similar to the USD- and Euro-denominated blocs of North America and Europe.

Bin Shi
Head of China Equities

Ten years ago, investors used to talk about the BRICS economies, i.e. Brazil, Russia, India, China and South Africa, being the new drivers of the global economy. Things have clearly changed because these countries don't get mentioned together in the same way anymore. That's because China has emerged as the main driver of the global economy, contributing an estimated

33% of global GDP growth in 2019, according to IMF numbers. And that should continue. There are a whole range of estimates on this but it is widely accepted that China will continue to be one of world's largest economies.

For equity investors, it means that China's stock markets will likely continue their growth path and become some of the largest in the world. This is already being recognized in the index inclusion process. If, as we expect, onshore China markets are fully included into the MSCI EM benchmark, China equities will account for an estimated 40% of that index alone.

The question for investors then is, given the size and growth of China's economy and equity markets, is a general exposure in an EM-focused strategy enough? We don't think so, and that's not just because of the projected size of China's economy and financial markets.

We believe that an active, standalone allocation gives investors a better chance of capturing growth opportunities in China than a generic allocation within an EM strategy. As China transitions to a services and consumer-led economy, many new drivers and innovative companies in the consumer, IT, healthcare sectors are emerging and outpacing the traditional investment-led sectors.

An active approach, supported by on-the-ground, bottom-up research, may cherry-pick the best opportunities in these fast-growing, emerging sectors in China before they are discovered by index-linked passive investment strategies.

Additionally, active strategies may take advantage of inefficiencies in China's equity markets. Retail investors drive China's markets, making them volatile and influenced by 'collective behavior.' This opens opportunities for disciplined, active strategies to exploit mispricing in ways that passive strategies may not.

In summary, given the ongoing growth story, the size of the economy, and the nature of Chinese equity markets, we believe that an active, standalone allocation, with strategies supported by on-the-ground knowhow, offers investors the best chance of capitalizing on the many opportunities emerging from China's growing role in the global economy.

Gian Plebani
Portfolio Manager

China Allocation Opportunity

Rob Worthington
Head of Investment Specialists, Investment Solutions

As China's onshore markets are included in global indices and their weighting increases, China will soon become the largest component for any emerging market indices. It would be a prudent and probably natural step to consider China separately from EM ex-China, much like the case for the US versus the World ex-US.

The relatively low correlation of China’s financial markets with broader overseas markets provides ample opportunities for portfolio diversification. And the large set of potential alpha opportunities, as discussed by our sector specialists, may make a China allocation even more attractive. To capture such alpha, however, could prove tricky and requires special skills and dedicated efforts.

Clearly the appropriateness of any allocation to China is dependent on each individual investor’s risk and return objectives. Our analysis shows that adding 5% and 10% dedicated China exposure to a portfolio, split 50/50 across equities and fixed income, can improve the risk-adjusted return profile of a hypothetical global portfolio, based on historic data, and that adding 10% exposure to Chinese assets improved the risk-adjusted returns potential more than adding 5%, based on historic data.

There may be investors convinced of China's growth story who just don't have the risk tolerance for a dedicated allocation to Chinese equities. In which case, China multi-asset strategies may offer investors a more 'risk-aware' exposure to Chinese assets that combines the undoubted growth potential of the China equity story with the more defensive, diversifying and income-generating characteristics of a China fixed income allocation.