China is one of two global equity markets where investors lost everything in the 20th century. When Mao Zedong and the communists seized power in 1949, property was declared null and void and equities became worthless. Including such cataclysmic events in their study of global asset returns since 1900, is how London Business School (LBS) professors Elroy Dimson, Paul Marsh and Mike Staunton avoid survivorship bias. First published in their book, Triumph of the Optimists (Princeton University Press, 2002), the research is updated to the start of this year as the Credit Suisse Global Investment Returns Yearbook 2019.
Now the world’s largest economy, according to the International Monetary Fund – by gross domestic product (GDP) measured using purchasing power parity (PPP) exchange rates – and the most important emerging equity market, China has come a long way since the days of Chairman Mao. Never mind the revolutionary nadir, in the past 20 years the country’s weighting in emerging market (EM) indices has grown 10-fold. Using a composite of MSCI, FTSE Russell and S&P indices, the LBS team reckon China constitutes over 30 per cent of the investible EM universe. This is set to increase, as more Chinese A-shares are approved for inclusion by western index providers.
Between 1980 and 2018, emerging markets’ share of the world’s PPP GDP has grown from 25 to 49 per cent, with much of this expansion driven by China. While their importance is steadily increasing, EM is still not quite 12 per cent of investible market capitalisation, so opportunities to invest in up-and-coming nations remain relatively inaccessible. Securities such as Chinese A-shares have been excluded from indices, and another factor is the lower free-float weighting of EM stocks, which tend to have a higher proportion of ownership by government and larger companies.
The academics calculate a 4.2 per cent average annual real rate of return since 1993 for the universe of investible Chinese equities. The difficulty in compiling investible benchmarks means there is huge disparity in the performance of indices from different providers. The FTSE China has seen a 10.3 per cent growth rate versus 7.4 per cent for the S&P China BMI and just 1.1 per cent for the MSCI China. Quirks in methodology account for these differences, including free-float adjustments (which must be more complex thanks to the ownership issues discussed), back histories and especially nationality criteria.
The latter point is important, as there is a distinction between the Hong-Kong-listed H-shares and the N-shares, which are vehicles for buying into Chinese equities listed on US exchanges. The addition of Chinese mainland A-shares (companies listed in Shanghai or Shenzhen account for 51 per cent of Chinese equities) increases scope for index providers’ benchmarks to differ.
Trade disputes with the US have contributed to China setting a more modest GDP growth target of 6-6.5 per cent for 2019 and the expansion of corporate debt – there is an estimated $40 trillion of assets on Chinese banks’ balance sheets – has alarmed many economists. Despite these concerns, the opening up of Chinese capital markets does broaden the global investment set, offering diversification opportunities.
Correlations between developed equity markets have risen since the early 1980s. Although an index of emerging markets had over 60 per cent R-squared versus the US equity market at the worst stages of the 2007-09 bear market (exploding the de-coupling myth), the figure for other developed markets and the US was over 80 per cent. Outside the worst of times, the correlation between EM and the US is much lower.
Despite the undeniable and significant risks of Chinese equities, the country’s need to continue integrating with the global financial system makes a repeat of the 1949 wipeout unlikely. As more A-shares come online for western investors, China should assume a weighting in EM indices as significant as that of the US in the developed market (DM) universe. The LBS team points out that, although the US has been the powerhouse of global equity returns from 1900, since 1950 EM has outperformed. Given the weak performance of DM other than the US, China’s growing importance means it should not be ignored by long-term investors.
