The Most Popular Conference Topic
Ask a CIO #10
It’s been a choppy week in both equity and bond markets.
Various narratives popped up quickly to try to explain the stock market drop. The great carry trade unwind. Weak unemployment numbers. Disappointing tech earnings.
After a tough start, the S&P 500 rebounded, and is down just 0.5% week to date.
How should we make sense of this experience? I’m not sure we need to right now. The narrative will become clear over time. Or we might all forget the market events of this week because they’ll be overshadowed by something else a month from now.
I’ll beat on the same drum – asset allocation is key, especially in moments of uncertainty. Let’s resist the temptation to overreact to market conditions, as I suspect there will be more volatility in the months ahead.
Following up on your piece regarding generalists and specialists – how should investors consider an allocation to China? Are investments in China going through a down cycle that could turn or a fundamental structural shift given heightened geopolitical tensions?
You’ve delicately framed a difficult question. The blunt translation – is investing in China out of favor, or has China become effectively un-investable?
I was really hesitant to take on this question. Institutional investors generally shy away from making macro predictions or major proclamations.
It’s not that we don’t think about these types of questions. We do.
And for this particular issue – whether or not to invest in China, how to invest in China – we think about it a lot. We talk about it a lot. Just about every major institutional investor conference includes a panel on the outlook for investing in China. I would wager it’s the most repeated institutional investor conference topic of the past 15 to 20 years (you’d think we’d be tired of it by now).1
Using our framework from last week, in my experience, China is unequivocally a market in which specialists have an advantage over generalists. But the bigger question of whether that merits a dedicated allocation is much less clear.
I’ll warn you, so you can stop reading if you want, that I’m not going to make any macro predictions or major proclamations here either. What I will do is share some data, some considerations, and then offer up a total non-answer.
First, some data, sourced from Bloomberg as of July 31, 2024.
The 20-year return for the MSCI China Index is 7.2%, which compares to 10.5% for the S&P 500 Index.
The 1-year year for the MSCI China Index is -12.4%, which compares to 22.2% for the S&P 500 Index.
The MSCI China Index has a rolling 3-year correlation of 0.2, and a rolling 10-year correlation of 0.4 to the S&P 500 Index. Relative to most global equity markets, China’s equity markets have a history of lower correlations to U.S. equity markets (particularly China’s A share market).
Some more data, from the World Bank.
The U.S. is the largest economy in the world, with a GDP of $27.4 trillion. China is the second largest economy, with a GDP of $17.8 trillion.
Since 1978, China’s annual GDP growth has averaged 9%. GDP growth was 5.2% in 2023 and is projected to be 4.8% for 2024. China has been, and continues to be, one of the faster growing global economies.2
Reflecting on the data, some considerations. I’ll summarize them as two opposing viewpoints.
Viewpoint #1: Over the past 20 years, dollars invested in China have endured higher volatility, greater capital market uncertainty, and more geopolitical risk for no excess return. Those dollars, had they stayed invested in the S&P 500, would have outperformed. And the owners of those dollars would have suffered a lot less heartburn.
On a go forward basis, China faces deep, fundamental, domestic challenges: a property bubble, demographic issues, and high unemployment among young adults.
Viewpoint #2: This is a moment in time. Predictions of a looming economic crisis in China have been a consistent part of the background noise for the past 20 years. Yes, the market has had a significant period of underperformance, but that has resulted in a large valuation gap – the MSCI China forward P/E is 9.13, the S&P 500 forward P/E is 22.2.4 The relative discounts are similarly wide in the private markets.
On a go forward basis, China is the 2nd largest economy in the world, with a massive existing consumer base that can continue to fuel domestic corporate growth. It is investing in technology and manufacturing, with visible results to date in electric vehicles and renewable energy.
Two rational, knowledgeable, thoughtful investors can look at the data and come to two very different conclusions. That’s the enduring challenge of investing in China, and why it will likely persist as a perpetual space filler at conferences.
Finally, my total non-answer.
You might have noticed that I really haven’t touched on the geopolitical tensions. They’re real, they’re not going away, and I have no special insights into how to probability weight the risks of direct or indirect conflict. Do you? If you do, then you can answer this question better than I can.
Otherwise, I think the path forward starts with first principles. Assume you have no China exposure in your portfolio (and perhaps that is the case), would you make a new investment? How much higher is the return expectation relative to your next best idea? Does the go-forward return expectation compensate you for the risks you’re taking? How are you quantifying the risks? Can you unwind the investment, and if so, what is the cost, and how long would it take? What are the consequences of miscalculation?5
I know how I would answer these questions, but this is one sphere where reasonable investors can reach very different conclusions.
Thanks to everyone that has sent comments and questions! I think we might need to tackle a slightly lighter, less loaded topic next week. As always, feel free to reach out at askacio@ivyinvest.co!
Until next week,
Wendy
AI is giving China a run for the conference money these days! Just 18 more years of AI topics to go, and then it’ll be even.
Experienced emerging markets investors will note that the promise, or even the reality, of fast-paced economic growth does not neatly correlate to outsized equity returns. In other words, GDP growth and stock market performance in emerging markets can be, and historically often has been, disconnected.
Source: MSCI China Index
Source: Bloomberg BEst P/E Ratio
In my former allocator seats, we were also navigating various stakeholders, many of whom have their own strong opinions on the risks of investing in China.