A modest trade deal can’t mask major problems between Washington and Beijing. But despite those tensions, Americans are unwittingly increasing their exposure to Chinese stocks and bonds.
Steven Schoenfeld
As officials from the United States and China navigate not only a trade war but also growing geopolitical competition—as well as a clash of values on issues such as Hong Kong, Taiwan, and Xinjiang—an incongruous trend is accelerating: Americans are unwittingly becoming more heavily invested in Chinese companies and government securities.
Surveys show that 55 percent of Americans own stocks, mostly relying on professionally managed pension funds, mutual funds, or exchange-traded funds (ETFs) to run their current investments and retirement accounts. Among those investments, a substantial 20 percent or more is generally allocated to international equities, usually in a mix of both developed and emerging markets. But while it is well known that both actively managed and index-based funds have global allocations, one trend that has developed under the radar is the fact that the weight of Chinese companies within emerging market allocations has grown dramatically in the last year, partly because of technical changes made by the three major index providers—MSCI, FTSE Russell, and S&P Dow Jones.
Foreign investment
In 2019, nearly $400 billion of new foreign investment into Chinese equities was driven by changes in allocations within benchmark indexes, with American investors accounting for more than a third of these massive portfolio flows. Similarly, global bond indexes that have started adding Chinese government bonds to their benchmarks accounted for an additional investment flow of more than $100 billion into China. Put together, these major shifts in fund allocations could automatically grow U.S. portfolio investment in Chinese companies and government securities to more than $1 trillion by the end of 2021, without the active consent or knowledge of most Americans.
This dichotomy—of Americans investing more in Chinese companies even as U.S. policies aim to punish China for its trade practices—poses significant risks. Not only will Americans’ portfolios become potentially too exposed to a single economy, but they will also be allocated to one that could be subject to U.S. sanctions or Chinese government controls. To manage these and other inherent risks, U.S. investors need to take a closer look at what is inside their professionally managed portfolios. Fiduciaries, investors, and their asset managers should look to similar historical market anomalies—such as with Japanese stocks in the late 1980s and the previously high weighting of Mexico, Malaysia, South Africa, and Taiwan in emerging markets—and consider alternative index construction approaches that moderate the investment concentration of China in their portfolios.
Since around the middle of the last decade—well before its trade spat with the United States became a regular feature of news headlines—China was already the largest component of the main emerging market indexes. As Beijing steadily lifted what used to be strict restrictions on foreign portfolio investment, the major providers of benchmark indexes embarked on a historic inclusion of locally listed Chinese companies within their emerging market listings. Those inclusions are accelerating—as announced to the financial community in early 2019—despite the new public policy environment of increased U.S. economic and geopolitical tensions with China.
As index-based investments surge—for example, now representing more than half of all new mutual fund inflows—the influence of global index providers has grown considerably. MSCI, FTSE Russell, and S&P Dow Jones collectively guide more than $20 trillion in global equity assets. The MSCI Emerging Markets Index, which guides more than $1.7 trillion in investments in 26 developing countries, completed a major inclusion of locally listed Chinese stocks at the end of November, which increased China’s total weight to more than 34 percent of the index as of January 2020—an unprecedented proportion for a single country. Similarly, the FTSE Emerging Index, the benchmark for nearly $1 trillion in assets, has recently increased its allocation to China to more than 37 percent, in turn impacting emerging market portfolios from Vanguard, the largest manager of mutual funds for American individual investors as well as others. S&P Dow Jones also has an emerging market index that now has approximately 37 percent of its investments allocated to Chinese companies. Each of these providers of flagship emerging market benchmarks have indicated plans to further increase the weighting of locally listed Chinese equities in the next five years. When these added allocations are enacted, China’s projected weight in emerging market indexes will rise toward 40 percent or more by the end of 2022. This added exposure to China will have knock-on effects. Other international equity indexes, which follow the allocations of popular emerging market indexes, and into which many American pension funds invest money, will also automatically tie a growing share of their savings to China.
Similarly, global bond indexes used by fixed income investors in the United States have a growing exposure to China. The International Monetary Fund (IMF) estimates $300 billion in increased index-driven bond investments in China by 2022.
China’s economy
Put together, the newly increased portfolio investments in China—and the prospects of further increases—have a tremendous impact that essentially contradicts current U.S. government policy.
Despite broad bipartisan consensus about U.S. efforts to constrain China’s economy, estimates by several major investment banks, the IMF, and BlueStar Indexes (which I founded) suggest aggregate equity and bond portfolio investment into China could exceed $800 billion between now and the end of 2023. Those investments will significantly support the Chinese economy and currency even as China’s current account balance has shifted to a deficit for the first time since 1993.
In other words, while China would otherwise face substantial pressure on its capital account, investment shifts that are virtually on autopilot from Americans and other global investors will materially contribute to relieving those pressures. Not only that but the efforts of the U.S. government to impact the Chinese economy through tariffs and other policies will also be counteracted by these portfolio flows. Put simply, the international investment allocations now being implemented by American investors are directly opposed to current U.S. trade and economic policy.
- Foreign Policy
Add new comment