Business

How to invest in Emerging Markets and Asia without direct exposure to China

Diversifying risk while enhancing return has usually involved investing in foreign countries especially in the emerging markets. Investing in Asia offers an investor both geographical diversification and access to high GDP growth countries. The International Monetary Fund estimates that emerging market economies will grow by 6% this year – a rate much greater than those of the U.S. and Europe. The first mutual funds and exchange traded funds (ETFs) that focused on these regions were created in the early 2000’s. Since then, assets invested in emerging markets have grown by an estimated $50 billion annually.

Most investors are unaware that due to the size of the Chinese economy with relation to its’ neighbors, most mutual funds and ETFs allocate an oversized portion to China. For instance, the Vanguard FTSE Emerging Markets ETF (VWO) is allocated 36.9% to China while the iShares MSCI Emerging Markets ETF (EEM) is allocated 34.4% to China.

Should China be avoided? We believe so and have changed our investment models accordingly. For the time being, we find China to be “un-investable.” In the past twelve months, the government has toughened regulations which has created a great deal of uncertainty in the business environment. Many of the largest publicly traded companies have a negative return year-to-date: Alibaba (BABA) -37%, Baidu (BIDU) -29%, Tencent Holdings (TCEHY) -14%, Xiaomi (XIACF) -41% and China Construction Bank (CICHY) -10%. The iShares China Large-Cap ETF, which is comprised of the 50 largest Chinese stocks, is down -13% over the same period. Additionally, the iShares Asia 50 ETF (AIA) is down -9% and holds 43.6% of its assets in Chinese equities.

Additionally, cracks in the Chinese real estate market have opened. Most noticeably among the over-leveraged real estate project developers. China Evergrande Group (EGRNF) and Modern Land (HK: 1107) are experiencing a debt crisis. We believe missed interest payments, debt defaults and restructurings should be expected. While the ultimate extent of the damage is currently unknown, it adds to our concern regarding direct investment in Chinese companies. Historically, the Chinese government would step in and support firms in financial trouble. This is no longer the case as evidenced by Evergrande’s billionaire founder, Hui Ka Yan, being forced to use his personal wealth to fund the company. Of note is the fact that Evergrande is the largest issuer of emerging market high yield debt.

Clear Prosperity recently assessed countries outside of China, including South Korea, Japan, Philippines, Thailand, Vietnam, Indonesia, Malaysia, Taiwan, India, and Singapore. Each country was evaluated based on its political stability, GDP growth rate and political and business relationship with China. Each country was required to have a suitable ETF to express the attributes each country was evaluated on. After screening, Singapore, Vietnam, and Japan were selected as the preferred investable countries. India and Thailand are on “watch list” status.

Review of the First Half of 2020:

The first half of 2020 saw one of the fastest market crashes in history followed by a rapid bounce back that defied many prognosticator’s forecasts. Stock markets around the world fell double digits in the first quarter 2020 (Q1) only to regain a large portion of the losses in the second quarter (Q2.) The table below shows returns for the major indices for the first half of the year.

Index	Year to Date Return Through June 30
S&P 500 (U.S. Large Caps)	-3.08%
Russell 2000 (U.S. Small Caps)	-12.98%
All Country World	-6.19%
International Markets (MSCI EAFE)	-11.07%
Emerging Markets (MSCI EM)	-9.67%
U.S. Aggregate Bond	6.27%

The only index to post a positive return was the U.S. Aggregate Bond Index. The return was mainly driven by the Federal Reserve Bank’s (Fed) intervention in the bond market, including the unprecedented action of buying bond Exchange Traded Funds (ETFs.) The S&P 500 gained 20.54% in Q2 yet ended the first half of the year down 3%. The Europe, Australasia, and Far East Market (EAFE) and Emerging Markets ended down 11% and 9.7% respectively. The All Country World Index, a measure of all stock markets, finished down 6%. It was buoyed by U.S. Large Cap Stocks which account for approximately 60% of the index.

While indexes are often reported on and discussed, they do not show the entire story. Markets are divided into sectors, or a grouping of companies with similar economic characteristics.  The S&P 500 is divided into 11 different sectors. Examining the returns of these sectors reveal a stark contrast between the winners and losers. The two tables below highlight the top and bottom performing sectors.

Top Three S&P 500 Sector Returns
Sector	Year to Date Return Through June 30
Information Technology	14.95%
Consumer Discretionary	7.23%
Communication Services	-0.31%
Bottom Three S&P 500 Sector Returns
Sector	Year to Date Return Through June 30
Industrials	-14.64%
Financials	-23.62%
Energy	-35.34%

Only two of the 11 sectors produced positive results. As populations worldwide were mostly confined to their homes, many individuals and businesses invested in additional technology in a bid to keep operations while working from home. Information Technology and Communication Services continued their strength from 2019 and stayed within the top three sectors. Energy continued its losing streak. Energy has been the bottom performer for 2014, 2015, 2018, 2019 and, now, the first half of 2020. The Energy sector is down 41% since 2014.

Preview of the Second Half of 2020:

At time of this writing, earnings season is just beginning. Company earnings for Q2 will be the first that fully reflect the impact that the COVID virus has had on companies. While past earnings will have some importance in terms of stock price, the company’s guidance regarding expected earnings for Q3 will be more impactful.

We believe areas to avoid going forward are banks and real estate (REITs), especially those with significant mall, commercial property, or restaurant exposure. Banks will be hampered by near zero interest rates and a lack of demand for loans. REITs will face missed rental payments, low occupancy, and lower rental prices. Restaurants will have to manage decreased demand and COVID related restrictions.

Stocks that we think have investable potential are technology, after a pullback, infrastructure plays and targeted energy companies. Technology has been on a tear for the past year and a half. The virus has done little to impact their earnings and, one could argue, the virus has actually increased demand for technology products. Infrastructure stocks are trading at attractive valuations and should benefit from increased government spending. We believe that Government spending will be required to help keep the domestic economy running. Energy stocks, specifically large oil, are appealing due to low valuations, healthy balance sheets which are flush with cash and the bounce back of oil prices. These factors will allow the larger oil companies to selectively acquire smaller energy companies at attractive prices. Chevron’s recent purchase of Noble Energy for $5 billion is a good example.

Overall, stocks to emphasize for Q3 and the remainder of the year are those that have a high fundamental quality factor—a strong balance sheet, a history of revenue and earnings growth and a high return on equity.