Beyond China: An emerging approach to Asian equities

Asia, a continent synonymous with diversity, dynamism, and economic ascendancy, has evolved to become a focal point for global investors seeking opportunities amidst a shifting financial landscape. Comprising a tapestry of cultures, economies, and geopolitical complexities, Asia stands at the crossroads of growth, innovation, and significant population dynamics. For 2024 for instance, the International Monetary Fund sees India grow by 6 percent and some ASEAN economies over 5%, compared to a global average of 3.1%.¹ As investors navigate this diverse region, a noteworthy strategic shift is gaining prominence—the exclusion of China from Asian equity investments. The rationale behind strategically omitting China from investment portfolios is based on a growing recognition of China’s economic and political weight on the world stage, as well as its resulting unique challenges and opportunities. We focus on four pillars: improved diversification, geopolitical risk management and flexibility, the current tactical view of China, and increased exposure to smaller yet dynamic Asian economies.

Improved Diversification

China’s rise over the past two decades or so has played a pivotal role in shaping Asia's economic narrative. Its rapid growth, technological advancements, and strategic importance have forced investors to reconsider their allocations to emerging markets and to Asia, in particular. Traditionally, most Asia indexes have excluded Japan, partially due to its dominance in market capitalisation, but also to account for Japan’s economic specificities. Currently, Japan accounts for roughly 41% of an All-Asia index. That is down 7 percentage points compared to ten years ago, but still too high for most investors’ understanding of a well-diversified allocation. China’s weight, meanwhile, has increased from 9 to 16%.²

Since in practice most investors already allocate Japan separately, this means China’s weight in ex-Japan allocations is has at times exceeded 30%. The country also accounts for over a quarter in emerging markets indexes.³ Increasingly, investors have begun to feel uncomfortable with such outsize influence of an individual market, regardless of their current tactical view of the country. From a portfolio construction and diversification perspective, it appears sensible to disaggregate Asia-ex Japan or emerging markets engagements further, and to manage allocations to China separately - for example with single-country ETFs. The decision to exclude both Japan and China strategically simply acknowledges the potential concentration risk associated with economic giants.

Geopolitical risk management and flexibility

Geopolitical tensions have been on the rise for years now, with the US-China relationship being under heavy pressure from a myriad of issues. Investors are also alert of risk scenarios that prior to Russia’s invasion of Ukraine appeared irrelevant or at the very least, far-fetched. There have been recent signs of a timid rapprochement between Washington and Beijing, but with a presidential election coming up in November, expectations of a comprehensive agreement on the superpowers’ multiple differences remain low. In fact, tail-risk events aside, for the years ahead investors ought to prepare for recurring bouts of volatility that are not driven by economics, but the geopolitical news flow. In such an environment, we believe that the concept of disaggregation will become more commonplace both among short-term traders and strategic investors. The option for flexibility and speed of execution in portfolio management will command a premium, even if the option is never exercised.

Tactical views of China

China equities performance over the past five years has seen pronounced peaks and troughs, but overall, returns have been challenging. The FTSE Asia ex Japan ex China Index outperformed its Asia ex Japan pendant by 30% points over five years, 23 points over 3 years, and by 1 point year-to-date.⁴ We continue to have a constructive view of China’s long-term opportunities – a country in a multi-year transition that at times will be painful, but potentially lead to more sustainable, albeit lower, growth going forward.  Many investors currently are more concerned about the numerous challenges and may consider tactically underweighting China – especially given its still-dominating weight in standard Asia and EM indexes. The country is not only at a different stage of the economic cycle than many other economies, but its entire economic model is quite unique. For investors who currently have cautious views of the short to medium term prospects, an ex-China allocation, combined with a single country broad China exposure can deliver the precision to better align their portfolios with their economic analysis.

Increased Exposure to Dynamic Asian Economies

Asia offers a diverse universe of economies that may be underappreciated in portfolios. India is one of the fastest growing major countries with solid short-term and long-term prospects. Taiwan and South Korea add first class technological capabilities that might shine bright again in 2024, while Hong Kong and Singapore are two of the world’s preeminent financial centres and trading hubs. Indonesia is the 4^th most populous nation, boasts the largest economy in Southeast Asia and accounts for roughly one-fifth of global nickel reserves. It is poised to play a key role in the electric vehicle supply chain.

Many of the above nations are well-placed to benefit from the proliferating “China-plus-one” approach to manufacturing. Redistributing China’s index weights across some of these players makes sense not only from a diversification angle, but also from an economic point of view.

The decision to exclude China from standard exposures represents a fresh approach to Asia equity allocations. We believe, however, that there is a long-term case to be made beyond tactical considerations. China’s importance as a country and economy and its dominance in Asia and emerging market indices suggests that a separate view is warranted. Geopolitical tensions ebb and flow, but the emergence of a superpower besides the US will continue. China’s growth trajectory is slowing, consistent with the fact that it has progressed to become a middle-income country and is on the verge of moving into the high-income bracket. Some of its immediate and regional neighbours on the other hand are picking up speed. Asia as an economic entity will increasingly drive the world’s growth, and many of the economies offer investors opportunities that may not be well reflected in standard exposures.