Following a particularly strong year for Chinese equities in the year of the rooster, investors have got their tails up in the hope of more of the same as we enter the Chinese New Year, transitioning from the rooster to the year of the dog.
Many emerging markets have entered 2018 on a high note, with many economies at their strongest in five years and overall sentiment positive.
Emerging market fundamentals started improving in 2016 and accelerated over the last year, with growth broadening across regions and countries.
But as the new year begins, is China still the major powerhouse of emerging markets, or should investors look elsewhere?
According to research from Bloomberg, China is one of the least attractive emerging markets for 2018, due to relatively expensive valuations in historical terms.
Bloomberg’s data highlights Mexico and Turkey as the most attractive markets, primarily due to the fact their real effective exchange rates are more competitive than the average of the past 10 years.
When it comes to bonds, the data shows that, for example, Turkey’s five-year government bond yield is around 13%, while Mexico’s is 7.5%, exceeding China’s equivalent rate of about 3.9 percent%.
But for equities, Alliance Bernstein portfolio manager John Lin argues that, looking at the price to earnings (P/E) ratio, Chinese equities are still attractively valued compared to other emerging markets.
MSCI China-A is valued at a forward P/E of 14.6x as of the end of January, Lin said, which is ‘substantially cheaper than US stocks and roughly on par with Japan’.
In terms of emerging markets as a whole, A-shares are more expensive than the MSCI Emerging Market as a whole at 13x forward P/E, but compared to Mexico for example at 16.6x don’t look that bad for value.
Lin said that while smaller markets like Turkey trade at a discount, ‘these emerging markets peers typically have a different profile of underlying earnings growth and risks associated with geopolitics or economic and currency stability.’
Can India take the mantle?
While for now China’s reputation at the top of emerging markets doesn’t seem like abating, many investors believe India could take that mantle within a decade.
India’s GDP growth has beaten China’s for a number of years now, and the country has also been favoured by some investors as its economy, unlike other emerging markets, isn’t dependent on commodity prices, with India importing 80% of its oil for example.
While its demographics are also attractive, with around half of the country’s 1.25 billion population under the age of 25.
But for the next 3-5 years at least, China still appears to be the most attractive option.
Ernst Knacke, fund research analyst at Quilter Cheviot, says China’s politics is playing a helping role, as president Xi Jinping acknowledges the country’s need to shift from focusing on production to becoming a more consumption-based economy.
Knacke said: ‘China’s income per capita is on the cusp of when people start to spend on luxury or discretionary products. Underpinning it all is the political backdrop, Xi Jinping’s vision is pro-growth.
‘He wants China to become a global consumption economy. The government is trying to fix supply-side problems and fix subsidiary mining firms supplying at below cost level. The Chinese government direction is very much aligned with supporting growth in consumption, urbanisation and the economy.’
Mark Williams, head of Asian equities at Liontrust, believes South Korea provides good value with stocks trading at a P/E ratio of less than 10x.
He said part of that is due to bad corporate governance, Samsung being a prime example, and investors being spooked by the country’s current issues with North Korea.
But he added that those problems are getting better under the new government of president Moon Jae-in, while companies themselves are making good progress on tackling corporate governance issues.
However the majority of Williams’ Asia Income fund is in China, and he believes the country's focus on tackling its debt makes it more attractive again.
He said: ‘Two years ago most meetings I went to in China discussed the country’s debt levels, and now I don’t have to have those conversations. It’s a big positive for markets.’
While the demographics in China are seen as negative, with an ageing population and workforce, the rising wealth within the population will lead to a rebalancing of the economy, Williams says, as China moves away from focusing on subsidising manufacturing and more towards being a consumption-driven economy to service its rising middle class.
He also points to the ‘functioning monetary policy’ in China and other Asian economies, where they don’t have low interest rates pushing up asset prices like in developed economies.
So how can investors find opportunities in China, and in particular its newly opened up A-shares market?
‘The A-shares market is dominated by mom-and-pop retail investors and is notoriously inefficient,’ said Lin. ‘That inefficiency makes for a fertile environment for disciplined, bottom-up investors to spot opportunities.’
Given there are now about 1,900 A-share stocks accessible to foreign investors through the Stock Connect scheme, more than doubling the current universe of stocks investible in China in offshore markets, Lin says fund managers with quantitative capabilities will have an edge.
But, he adds, there’s no substitute for boots on the ground, with a thorough understanding of how China’s top-down politics ripple through the economy key to investing in onshore equities.
He says: ‘Fund managers must be armed with field research from professionals with deep experience on the ground in China.
‘These analysts need to be fully versed in the nuances of China’s growing economy, know the players inside and outside of the companies, and be able to identify firms with good governance.’