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Navigating the China Syndrome

After a strong start to 2021, EM equities are broadly flat for the year as we enter the fourth quarter, underperforming global equities year-to-date by around 15%[1]. It has been a bumpy ride for investors – the MSCI EM Index fell 14% from its February high to its August low with many dips and climbs in between – a reminder that emerging market investing is rarely a smooth journey.

There are several reasons for EM's jagged descent with most linked to China, which has fallen over 30% since its February peak[2]. The main driver has been a series of regulations restricting Chinese companies across a range of industries, notably technology, while concerns over financial contagion stemming from the collapse of property developer Evergrande have extended the sell-off.

While China represents only 4% of the global index, it makes up a third of the EM equivalent (the MSCI EM Index excluding China is up 11% for 2021). Although the impact of its correction on EM more broadly has been softened by other countries performing strongly, it provides a reminder that the fortunes of many companies outside China – both in EM and DM – remain tied to its economic outlook.

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China drawdown in context

The latest Chinese meltdown is the fifth time stocks have fallen over 30% since the turn of the century and equivalent to the previous correction in 2018 when China was involved in a trade war with the US. By comparison, global equities have fallen 30% on three occasions over the same period while EM stocks have suffered it six times. Across all markets these losses have usually signalled the market bottom and been followed by powerful recoveries.   

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Ahead of the recent correction, Chinese equity valuations were high, particularly for consumer and technology companies. China was one of the strongest markets in 2020, climbing 26% and comfortably outperforming emerging market (+17%) and global (+12%) equities[3]. China's technology sector was also over-represented – the MSCI China Tech 100 Index more than doubled last year on the back of 36% gains in 2019[4] – and was always vulnerable to the heightened scrutiny we are seeing from regulators globally. Financial risks were also higher than many estimated with the Chinese government's focus on real estate starting back in 2020.

Despite the negative stock market reaction, greater regulation should be welcomed in the long run as it will hopefully clean-up China's financial system and improve competition in the technology sector. The Evergrande 'solution' is likely to involve asset disposals to SOEs, the winding down of rogue operators and accepting a lower growth rate for the country's economy in exchange for reduced systemic financial risk.

In investing risk is a measure of what can rather than what has happened. Short-term uncertainty over further government intervention means China's risk premium is likely to remain high but this also brings higher potential rewards, particularly for those selecting the right companies.  

Valuations compelling

SKAGEN Kon-Tiki remains underweight China with 27.4% of assets invested there but the fund has been caught up in the sell-off through its exposure to insurance conglomerate Ping An (5.4% of NAV) and technology companies Alibaba – the first company targeted under regulatory tightening of internet businesses (3.0% of NAV) – and Tencent – largely through holding companies Naspers and Prosus (6.4% of NAV combined).

Ping An is the portfolio's largest detractor this year as a result of weak new business sales and fears over its property market exposure, which we estimate at 6% of investments. The insurer's share price has stabilised since it released a statement saying it had no exposure to China Evergrande.

Fortunately, many of the fund's non-Chinese holdings have performed strongly and Kon-Tiki approaches the fourth quarter of 2021 broadly in-line with its benchmark year-to-date. These include UPL, Assai, Ivanhoe Mines and Sberbank with more details available shortly in our Q3 report.

While it is impossible to know what will happen tomorrow or even next quarter with certainty, valuation is usually a reliable guide to future returns. EM equities are currently at 20-year lows relative to the S&P 500 Index and at a level which has historically preceded a sustained period of positive returns. The Kon-Tiki portfolio currently trades at a 40% discount to the broader EM market on both a P/E (2021 earnings) and P/B basis and with 55% upside based on conservative price targets. For long-term investors who are prepared to accept volatility in search of superior returns, the opportunities in EM have rarely looked better.

NB: All information as at 31/08/21 unless stated.

References

[1] Source: MSCI as at 27/09/21: MSCI EM Index -0.3%, MSCI AC World Index +14.3% (both in local currency).
[2] Source: MSCI China Index -32.6% 17/02/21 – 20/08/21 (in local currency).
[3] Source: MSCI: MSCI China, MSCI EM and MSCI AC World Indices (all in local currency).
[4] Source: MSC: MSCI China Tech 100 Index (USD) +110.3%.

 

Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager's skill, the fund's risk profile and management fees. The return may become negative as a result of negative price developments.

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