Why we've reduced exposure to China in favour of other emerging markets

At a glance: 

• Exposure to a broad emerging markets basket, via the iShares MSCI Emerging Markets Investible Markets index ETF, has been reduced.
• We have also sold out of UBS MSCI Emerging Markets Social Responsible ETF, though exposure has been retained in our Socially responsible investing portfolios. 
• We have invested the proceeds into iShares MSCI Emerging Markets ex China ETF, which as the name suggests excludes holding in China. 
• Reasons to reduce Chinese equity exposure included underperformance, economic headwinds, and the relative attractiveness of other emerging markets in Asia and beyond. 

China's weight in emerging markets

Emerging markets remain a pillar of growth for the world economy. When combined, they currently represent 11% of the world equity market, which is more than twice any single developed country excluding the US.

The weight of Chinese equities in the emerging market index has fluctuated over time, growing from just 5% in 2000, to more than 40% at the height of the pandemic in 2020, and at a current value of around 25%. The decrease in relative weighting was largely due to underperformance versus other countries, though China remains the largest country in the index, and so it has a meaningful impact when it underperforms.

Chart : Equity cap size as % of total EM basket

Source: Macrobond, MSCI

We believe that the Chinese economy, and therefore Chinese equities, will continue to face significant challenges in the coming months. We see China as currently less attractive than other emerging nations forming the bulk of the index. 

Why China has underperformed

As we entered the Year of the Dragon in February 2024, Chinese authorities revised their growth forecast for the economy down to 5% for 2024, which was among the lowest estimates in recent history. 

There were expectations that the pace of economic recovery would be rapid following the decision at the end of 2022 to remove long-running Covid restrictions. However, this economic growth has yet to happen. 

So, what's holding the economy back? A big headwind for China is recent problems in its real estate sector, which was previously a key pillar of Chinese growth.  

A single number is quite symbolic of the current economic situation: year-on-year inflation published in April 2024 came in at 0.1%, well below consensus of market analysts.

Presently, most developed economies from Europe to the US, and even Japan, are seeing the highest levels of inflation since the 1980s. The fact that China might be approaching negative inflation says much about the relative slowdown in the economy compared with its history. 

Further to this, considering the upcoming US election, China remains something of a 'punching bag' for US politicians. We could see increased tariffs or new sanctions from both Republicans and Democrats alike, and this is could discourage companies from investing further into Chinese equities. 

The rise of Asian neighbours

We also have to consider that three other large components of the MSCI Emerging Markets index (India, Taiwan and South Korea) continue to be an attractive prospect for investors. These economies are home to some 'local champions' that are not only unaffected by what's happening in China, but could also benefit from its problems. 

All three economies have a strong technology bias, delivering strong growth output. In Taiwan for example, TSMC (Taiwan Semiconductor Manufacturing Company) has become an incredibly large and profitable player in recent years. It has benefitted from being able to export its high-tech, high margin products to the rest of the world.

In South Korea we have Samsung, which bypassed Apple as the top seller of mobile phones in the first quarter of 2024 and remains at the forefront of innovation in that sector. India, meanwhile, has seen a phenomenal rise in the fortunes of its software sector.

Brazil, Saudi Arabia, South Africa, and Mexico are all benefitting from increased commodity prices in 2024, which has boosted equity markets. 

So, what has Nutmeg done in response?

For these reasons, we have decided to alter our emerging markets exposure, indirectly reducing our allocation to China by favouring other emerging countries which offer more attractive prospects currently.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.