A plethora of US tariffs on a wide range of exports and a squeeze on tech companies in particular may have pushed Chinese equities into a corner, or have they? Is the effect felt widely, or only in selected market areas, and have Chinese equities decoupled from the broader emerging market space?
- Affecting Chinese equities: tariffs and technology bans
- Tech bans, notably the ones related to perceived US national security threats, are likely to remain
- This matters more for stock pickers than for asset allocators
Two aspects of the US trade war affect the outlook for Chinese equities:
- tariffs – these have already had a meaningful impact on the Chinese economy and financial market: exports to the US have fallen by 17% YoY; GDP growth is the slowest since 1992; sales by Chinese technology companies to the US have dropped by 14%
- technology restrictions – these are likely to remain in place, regardless of who wins next year’s US presidential election.
Do we need to consider Chinese equities separately from the rest of emerging markets?
First, let’s put things into perspective. So far, the US restrictions have mostly targeted companies producing 5G technology (notably Huawei, which anyway is not publicly traded) and those using artificial intelligence for surveillance equipment. While bans can have dramatic consequences, the sectors concerned are a small part of the Chinese stock market.
The IT sector accounts for just 3.7% of the MSCI China index and 0.8% of the MSCI Hong Kong index. Many of the smaller AI companies are only part of the MSCI China A Onshore index (generally not invested in by foreigners), where IT accounts for 13% of the market capitalisation.
Mind the sector classification changes
One simple reason that the IT sector share is so low is that many stocks were moved to other sectors after the 2018 reorganisation of the GICS sector hierarchy. Companies in the internet software & services industry (e.g., Baidu, Alibaba, and Tencent: the BATs) were re-categorised as communication services and consumer discretionary companies.
An aside: one concern about the S&P 500 performance in recent years has been the outsized contribution by the FAANGs. While strictly true, the contribution of the BATs to MSCI China’s return has been even more disproportionate: since November 2015, the MSCI China index has returned 7.4% annually in local currency terms, while the BATs have gained 16.4%. The rest of the index advanced just 3.7%.
Correlations remain, as does the China premium
Since the trade war began, Chinese equities have underperformed the rest of the emerging markets by 20 percentage points. There is a significant gap, though, between the performance of the tech sector and the rest of the index: the non-tech parts of EM ex-China have lost 1% since January 2018, while non-tech China has fallen by 17%.
By contrast, emerging market ex-China tech stocks have rallied by 15%, while China’s tech sector has dropped by 13% (including A share onshore stocks).
Exhibit 1: Relative performance: tech vs. non-tech for China and emerging markets (2009=100)
Data as at 19 November 2019. Note: Local currency total return. Source: FactSet
So, for now, the Chinese equity market continues to behave as before: correlations with the rest of emerging markets are high; the potential returns in most sectors are attractive. While US bans will likely impact the tech sector significantly, the effect on the wider market should be relatively small.
And don’t lose sight of who benefits: Ericsson, one of the few other producers of 5G technology, has outperformed the communications equipment index by 50% since early last year.
The implications then for asset allocators of a ‘tech cold war’ may not be that dramatic. For stock pickers, however, this is yet another example of how disruptive change creates opportunity.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
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