How Exposed Are Your Developed Markets ETFs To Chinese Slowing? by Bryce Coward, CFA, Gavekal Capital Blog
Many investors in ETFs that focus on developed market stocks may be more exposed to slowing Chinese and emerging market growth than they realize.
China and other emerging markets have become a larger and larger driver of global growth, but their slowing growth rates affect some economic sectors much more than others. Why is this so? China and other emerging markets have grown to become the marginal source of global demand for commodity and infrastructure related goods as their investments in infrastructure exploded between 2002-2011. For this reason economic sectors that sell or use commodities as an input in their final goods are disproportionately affected, both on the upside and the downside, by emerging market demand for those goods and the commensurate price changes. Companies engaged in the financing of commodity related companies and infrastructure development are also affected significantly as well. These economic sectors we are speaking of include energy, financials, materials and utilities.
So why should investors in diversified developed markets ETFs care? There are at least three reasons. First, it’s not just emerging market companies in the energy, financials, materials and utilities sectors that are affected by slower Chinese and emerging market growth more generally, it’s developed market companies too, from Australia, to Germany, to the US. Second, slowing or declining growth in the demand for products sold by companies in these sectors will probably continue for another decade as China rebalances from an investment led growth model to a consumption led growth model. Finally, the most widely used diversified developed markets/international ETFs have a 33% weighting to these four sectors, which could be much more exposure to slowing EM growth than investors want.
Point 1: Even Developed Market Companies are Affected
The slowdown in emerging market demand for commodities is felt everywhere. We see it everyday in the falling price of commodities and emerging market stocks, but it’s also apparent among developed market stocks as well. In the two tables below we aggregate bottoms up company sales estimates for the next four years for all ten economic sectors. The first table shows averages for just emerging market companies and the second table shows averages for just developed market companies. What is apparent is that the four sectors we highlight as having outsized exposure to EM growth rates are expected to be among the slowest growing sectors in both the emerging and developed markets, financials to a lesser extent.
DM Sectors:
EM Sectors:
Point 2: Growth Rates in Commodity/Infrastructure Sectors Will Probably Slow Further as China Rebalances
China is at the beginning of a transition from an investment driven growth model to a consumption driven model. This transition requires at least three things. First, a massive and sustained decline in fixed asset investment as a percent of GDP. Second, a massive and sustained rise in the share of consumption as a percent of GDP. Third, a much slower growth rate of the economy as a whole. We estimate that China must lower investment as a share of GDP from about 46% to about 35% and raise consumption as a share of GDP from about 38% to closer to 50% and we think that this rebalancing could take a decade.
In the first chart below we depict the current and likely future paths of both investment and consumption as a share of Chinese GDP. China’s economy will, one way or another, undergo a flip flop. For commodities this has major implications as the largest source of marginal demand growth grinds to a halt. The second, third and fourth charts below depict a simple estimate of the likely future path of investment as a share of GDP overlaid on the price of copper, the CRB raw materials index and oil, respectively. Simply put, as China moves away from an investment led growth model the pressure put on commodities will be brutal and enduring. For companies that sell or finance raw commodities or use commodities as a major input in the production of their goods (commodity pass through plays) this has major implications for top and bottom line results.
Point 3: The Largest Developed Markets ETFs Have Huge Exposure to Companies Most Affected by Chinese Rebalancing
The largest ETFs in the World Stock Morningstar category – which is the category for ETFs that invest in developed market companies all over the world – have a substantial weighting to the energy, financials, materials and utilities sectors. The ten largest World Stock ETFs have about $20.5 billion in total assets, of which $6.8 billion is invested in those four sectors. As the table below shows, the weighted average combined exposure to the energy, financials, materials and utilities sectors is 33.2% and the average weighting is 35.4%. Simply put, these ETFs are highly exposed to the negative effects of Chinese rebalancing and are commensurately underexposed to the positive side effects like faster growth in consumer, health care and tech related goods and services.
Solution to the Problem
No one is forcing investors to take on the risks associated with Chinese rebalancing and slower EM growth, but the roster of investable products is certainly an impediment. Our solution to this problem is the Gavekal Knowledge Leaders Developed World Index. Our smart beta index addresses the reality that companies and economies are becoming less capital and commodity intensive, not more. Through allocating to highly innovative companies, the index has outsized exposure to the areas of likely future growth while downplaying areas in secular decline. The Gavekal Knowledge Leaders Developed World Index has a combined weighting to the energy, financials, materials and utilities sectors of just 12.4% with the rest being allocated to the higher growth areas likely to benefit from the change afloat. The index starts in April of 2000 and has a since inception total return of 243% versus the MSCI World Index total return of 64.04%.
