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Global Emerging Markets ex China: Emerging as its own asset class


Fidelity - Research team

The headline story of the global emerging market complex over the past two decades has been China’s rise from a developing country to the brink of high-income status. It has caused two major paradoxical effects on emerging markets portfolios: they have risen in value mirroring China’s own trajectory, but they have also become increasingly dominated by China and therefore vulnerable to any drawdowns in China. This has meant exposure to other countries has fallen and the desirable characteristic of diversification has become less pronounced.

For investors, allocating to global emerging markets excluding China is becoming an increasingly compelling proposition that can offer a better balance in country and sector weights, and boost diversification. GEMS ex China contains a broad, diverse universe and has historically demonstrated good performance.

Global emerging market portfolios are dominated by China

A typical global emerging market portfolio 20 years ago would have an allocation to China of around 5%, with the largest weight in South Korea of around 10%. Today, the largest weight is China, which is responsible for nearly 40% of the index, and it’s continuing to grow.

China is the second largest economy in the world and has the second largest equity market. Given China’s rate of economic growth and the ongoing inclusion of China A-shares in indices, the weight of China in emerging market indices is expected to increase. If China onshore stocks are fully included in the MSCI Emerging Market index, the total weight of China would be close to 50%.

China increasingly dominating the emerging markets indices


Source: Fidelity International, MSCI EM country weights, calendar year data to 31 December 2020.

The rapid evolution of China’s economy is like nothing we have seen in modern times. China has separated itself from the rest of the BRIC countries (Brazil, Russia, India) and at the same time, many emerging market countries’ economies are more closely intertwined with China’s than ever. South Korea, Taiwan, Malaysia and Brazil are largest weights in emerging market indices after China but also have extensive trade links with the country.

For emerging market investors, the dominance of China both directly and indirectly, and conversely the lack of exposure to other developing countries, is increasingly posing problems around performance and correlation, and undermining the diversification benefits of emerging market portfolios.

The impact of China’s growth on emerging market performance

Prior to 2010, the performance of emerging market indices diverged from China and more closely tracked the EM ex China index. This indicated that China had a relatively muted influence on the overall emerging market index. Over the past decade, however, this has reversed.

Since 2010, the emerging market index has converged to the performance of China. The level of Chinese influence on the emerging market asset class can be clearly seen during this year’s Chinese equity sell off, which neutralised the strong performance in EM ex China stocks, leaving the overall emerging markets index flat. China, it seems, is weighing heavily on emerging markets.

EM performance is increasingly converging to China


Past performance is not a reliable indicator of future returns.

Source: MSCI, Refinitiv, 31 August 2021. MSCI indices.

The pull that China exerts on emerging markets can be seen in return correlations. Over the past three decades, emerging market indices and China have become more correlated. In 1993, the correlation was around 0.5, but this has gradually trended to one. This risks undermining the diversification benefits of the emerging market asset class.

China-EM correlations trending to one


Source: Fidelity International, Refinitiv, September 2021. MSCI indices. Daily data.

For example, during the China equities sell off in 2000, the correlation moved deeply negative as the sell off had little impact on the upward moving MSCI Emerging Market index. There was more of an impact during the 2015 sell off, but correlations still moved negative at one point. This summer’s China equities sell down has barely nudged correlations and they remain near 1.0, indicating that emerging markets are moving in closer lockstep with the Chinese market.

Sector and company performance

If we look at emerging market sector correlations during this summer’s China equities decline, we observe that the sectors with the largest falls experienced the biggest spikes in correlation.

Chinese sectors such as communication services, healthcare, real estate and consumer discretionary, which fell the most during the July to August drawdown (28/06/21 - 20/08/21), saw their correlations with their emerging market counterparts go to 1.0, considerably exceeding the correlations seen over the previous five years. This is precisely the time investors would want correlations to remain stable to protect them from individual country declines.

Conversely, materials, one of the few sectors that rose during July and August, saw its correlation with emerging markets fall, again moving unfavourably for investors.

Correlations spike higher in biggest drawdown sectors


Source: Fidelity International, Refinitiv, September 2021. July-Aug period covers 28/06/21-20/08/21. MSCI indices.

On a stock level over the summer drawdown, we can see how the performances of the biggest Chinese companies influenced sectors. In the five most positively correlated sectors, the returns of the highest weighted Chinese companies diverged from their emerging market counterparts, sometimes by a significant margin. Despite this difference, the correlations between emerging markets and China in each of these sectors were close to 1.0.

Performances of the largest stocks in each sector (China vs EM ex China July-Aug 2021)


Past performance is not a reliable indicator of future returns.

Source: Refinitiv, September 2021. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.

Stripping out China from emerging market indices

Given the dominance of China in emerging market indices causing the latter to be highly correlated with China, potentially exposing investors to undesirable outcomes such as the drawdown event we saw in China this summer, it is worth investigating what an emerging market ex China strategy looks like.

Firstly, we see much more balance in index weights. The emerging markets ex China index is not dominated by an individual market, and instead, Taiwan, South Korea and India form the largest and similarly sized weights, Brazil and Russia become larger contributors, and a long tail of nearly 20 countries in aggregate hold the biggest weight. The emerging markets ex China index contains 677 constituents and covers approximately 85% of the free float-adjusted market capitalisation in each country.

Emerging markets ex China index is not dominated by a single country


Source: MSCI, 31 August 2021.

In terms of sector allocations, there are some notable differences. The bigger country weights of Taiwan and South Korea mean that IT features more prominently in the emerging markets ex China index. ‘New economy’ sectors such as consumer discretionary and communication services, where many internet companies reside, have significantly lower weights because these industries are in earlier stages of development outside China and, as a result, have substantial capacity for growth. The natural resource sectors of energy and materials form a larger bloc in emerging markets ex China given the commodity rich regions of EMEA and Latin America.

More exposure in IT and smaller weights in the new economy 


Source: MSCI indices, 31 August 2021.

At the stock level, there is a deep pool of growing companies with strong earnings growth and profitability, with the 75th percentile of companies registering results in the high teens on both measures. The new issue market is also healthy with an abundance of IPO activity and is generally upward trending - over US$40 billion in new paper was issued in the year prior to Covid.

In terms of performance, emerging markets ex China has delivered higher price returns since 1999 than either emerging markets or developed markets. Volatility over the period has averaged around 17% and corelation with developed markets has averaged 0.6.


Past performance is not a reliable indicator of future returns.

Source: MSCI, Bloomberg, Goldman Sachs, Dealogic, 2021.

GEMs ex China performance


Past performance is not a reliable indicator of future returns.

Source: Fidelity International, Refinitiv, MSCI Indices, September 2021.

GEMs ex China: Supported by long term drivers

The late 1960s/early 70s period is generally thought of as the time when Japan morphed into a developed country. With its highly advanced economy, deep pools of savings and long investment history, Japan is often treated separately and excluded from many regional Asian benchmarks. Today, China appears to be on the cusp of breaking into advanced economy status and carving out its own identity as an investment destination.

It’s clear that China’s economic success has increasingly made it appear too big for the emerging market index. As a result, more and more capital is being allocated to China on a standalone basis, while investors are looking at emerging markets ex China as an complimentary strategy.

Stripping out China from the emerging markets index, offers investors better diversification through more balanced country and sector exposures. It allows investors to take advantage of the relatively less developed ‘new economy’ sectors, which have substantial growth potential. It’s a region with a rich pool of highly profitable, fast growing businesses and a strong pipeline of new companies coming to market.

The emerging markets region outside China is also an area of considerable economic potential. While China is approaching high income status, with economic growth slowing down and unfavourable demographics, the broader emerging market region still has room to develop. Its economic growth rate is high, the population is relatively young and there is a burgeoning middle class. These factors promise to underpin the region’s growth over the long term. With this profile, GEMs ex China is increasingly emerging as its own unique asset class.



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Risk warnings

  • The value of investments and the income from them can go down as well as up and investors may not get back the amount invested.
  • Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
  • Investors should note that the views expressed may no longer be current and may have already been acted upon.
  • Past performance is not a reliable indicator of future returns.


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