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Regina Chi is vice-president and portfolio manager at AGF Investments Inc.

China equities are, for lack of a better word, hot. They have staged a remarkable rally since the depths of the global market selloff last March, and it has accelerated since late December. Small wonder. China, once the epicentre of the global pandemic, has been the first major economy to emerge from the outbreak’s deleterious impacts.

Unlike the on-again, off-again rebound in Western economies, China’s recovery has been truly V-shaped, with only minor resurgences in COVID-19 cases and containment measures since the height of the pandemic in early 2020. Now that recovery seems complete. In fact, China is likely to come in as the only major economy in the world to have grown at all in 2020, albeit at a modest (by China’s standards) 2.3 per cent, according to estimates.

Clearly, global investors have placed the pandemic woes of the world’s second-largest economy, along with the contentious Trump era of U.S.-China relations, firmly in the rear-view mirror. Yet the important question now is what happens next. And when we look forward, we believe future Chinese stock returns might be moving into a more modest period. Indeed, it might be time for investors to begin looking elsewhere for opportunities in emerging markets (EM) – especially, in our view, India.

For one thing, we question how much further China equities can climb. In January alone, the MSCI China Index gained 7.4 per cent (in U.S. dollars), compared with a 3-per-cent rise in the broader MSCI EM Index and minus 1.1 per cent in the S&P 500, according to Bloomberg data. Go back over the past 12 months, and the outperformance is even more remarkable. The China index has risen 46 per cent over that period, while the broader EM index has returned (a still remarkable) 28 per cent and the S&P 500 “only” 17 per cent. Is that sustainable? Maybe. Yet we suspect that the good news on COVID-19 and whatever optimism is justified on the trade front have been largely priced into the market.

Speaking of trade, we are somewhat skeptical that the Biden administration heralds a dramatic thawing of U.S.-China relations. American public opinion remains firmly anti-China. And President Biden’s candidates for top cabinet posts on the China file suggest that a hard U.S. line will continue. U.S. tariffs on Chinese goods are likely to remain high compared with the pre-Trump era. And the shift in U.S.-China relations might end up being more in tone (more multilateral, less volatile) than in substance. That could well cap the upside of China equities in the medium term.

In contrast, we see significant potential for India’s economy and its equities. The MSCI India Index has performed strongly over the past 12 months, rising about 21 per cent, Bloomberg data show, but structural reforms under Prime Minister Narendra Modi could bear further fruit. Among other initiatives, the country’s Make in India 2.0 initiative calls for more private capital and foreign direct investment, and also the opening up of agriculture and lower taxes for manufacturers.

Of the latter, we see particular promise in India’s pharmaceutical sector. The pandemic has exposed the critical nature of pharma supply chains as never before. China holds 35 per cent of the global active pharmaceutical ingredient (API) market – valued at more than US$180-billion in 2019 – and Hubei, which is among the three largest manufacturing provinces, was deeply affected by the pandemic. Now Mr. Modi is making robust efforts to bring API back to India. The government has already approved a promotion scheme offering grants and incentives for the domestic manufacture of APIs and key starting materials (KSMs).

Finally, India’s much anticipated 2021-22 budget did not disappoint earlier this year. It rightfully focuses on growth and has, accordingly, relaxed the government’s medium-term fiscal-consolidation targets. It struck the right chords by increasing transparency (bringing some off-balance-sheet liabilities back on the books), doubling down on budgetary capital expenditures, budgeting revenues conservatively (in fact, too conservatively), seeking to jump-start asset sales and signalling an intention to commence some financial-sector reforms. Larsen & Toubro Ltd., one of India’s largest engineering and construction firms, stands to benefit from this new growth cycle and the government’s commitment to infrastructure spending.

Let us be clear: In advancing a case for India, we are not suggesting that the rally in Chinese stocks has definitively run its course; we are merely suggesting that the days of China as an investor’s emerging-market darling might be numbered. Even if they are not, its volatile stock-market history argues for diversification. In our view, therefore, investors should consider looking beyond China to seek upside and hedge risk in their emerging-market equity allocations. India is a good place to start.

Full disclosure: AGF owns stock in Larsen & Toubro Ltd.

The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.