Chinese equities, which typically make up at least 30 per cent of the MSCI Emerging Markets index against which £1.44trn in assets are benchmarked, have recently joined their Turkish counterparts in bear market territory.
The Shanghai Stock Exchange Composite equity index has fallen more than 20 per cent from its January peak in local currency terms, the common threshold for a bear market.
China’s big weighting in the benchmark emerging market equity and woes for most other emerging markets meant that withdrawals from the iShares MSCI Emerging Markets exchange-traded fund reached a record £2.29bn in the week ending 22 June.
Investors have become increasingly concerned about the economic outlook for China.
Fears about the impact of US trade and investment restrictions and a potentially full-blown global trade war have retaken centre stage in the last few weeks, after president Trump formally approved hefty tariffs on $50bn (£38bn) of high-tech Chinese products.
Credit tightening, tighter banking regulation and underwhelming data have also fed into concerns that economic growth will slow materially, undermining the investment case for the second-largest economy in the world.
With regard to trade, it does not seem likely that the worst of the rhetoric will materialise, at least not for some time yet and will unlikely last for long.
It is more likely that the US tariffs introduced to date and threats of additional restrictions on trade and foreign investment are Trump’s gambit towards more constructive talks on how to reduce America’s £267bn annual trade deficit with China, talks which are in both parties’ interests.
This is not to say that the current situation does not pose risks for trade and growth, but rather that these risks have been somewhat overblown.
Another reason to remain sanguine is that earnings growth is expected to remain strong over at least the next couple of years.
Although a material fall in the rate of growth is expected from last year, a particularly strong one for emerging markets in general, analysts still expect earnings growth of 14.3 per cent this year and 14.8 per cent in 2019 (estimates from JP Morgan research).
Made in China
The recent sell-off has also caused the stretched valuations of late 2017 to come down slightly towards fairer levels. Therefore, the recent market correction could offer a buying opportunity for investors with a strong positive view on the fundamentals.
One reason to hold such a view over the longer term at least is the government’s structural economic reforms. Xi Jinping’s Made in China 2025 strategic plan is expected to move China’s industry up the value chain, with new economy sectors such as technology and pharmaceuticals taking the place of more traditional credit-intensive industries.
There are concerns the People’s Bank of China manufactured the recent slide in the renminbi to offset the US tariffs
As well as contributing to the government’s longer term of deleveraging the economy, the plan could also create new investment opportunities within sectors that have typically been inaccessible to global investors.
This should be facilitated by the index provider MSCI gradually incorporating more of the Chinese onshore A-share market in the benchmark Emerging Markets index, in addition to the offshore-listed Chinese companies that typically made up more than 30 per cent of the index.
Although the immediate impact on flows into the A-share market seems to have been muted, we would expect a greater impact on full inclusion, when Chinese A-shares could account for 17 per cent of the MSCI Emerging Markets index.
Despite the greater access to previously inaccessible areas of the Chinese equity market, A-share inclusion may not provide a massive boost to flows into Chinese equities, with currency fixing and government intervention in corporate governance still concerning investors.
The government has also recently shown that it is willing to hold off on its goal of deleveraging the economy to stabilise markets. It has lowered reserve requirements for big banks three times this year and there are even concerns that the People’s Bank of China manufactured the recent slide in the renminbi to offset the adverse impact of US tariffs on net exports, a key driver of economic growth.
Despite these concerns, investors should remain cognisant of the longer-term drivers of earnings for Chinese companies and not overreact to the latest fluctuation, which seems to have been driven by trade rhetoric, something that should not be expected to translate into a significant reduction in global trade and growth.
Jake Hitch is research assistant at FE