Bloomberg: China’s purported disengagement from emerging markets may turn out to be a mistake

A gap has opened between Chinese stocks and the rest of emerging market stocks in recent weeks as pandemic recoveries have diverged. That parting of the ways is likely to be short-lived, fund managers say, Bloomberg reports.

Chinese stocks are seen as making up lost ground as extreme pessimism about its economy recedes and authorities take further steps to revive faltering growth. At the same time, the enthusiasm gathering for stocks in other developing countries could fade amid a global slowdown, causing their correlation with China to return.

“I’ve seen this decoupling story many times over the past two-plus decades, it never rings true,” said Zhikai Chen, head of Asia and global emerging market equities at BNP Paribas Asset Management, which oversaw the equivalent of $504 billion .dollars worldwide at the end of June. “In terms of trade flows and how big the Chinese economy is for commodity demand, it looks like a heroic case.”

The MSCI China Index has fallen about 6% in the past month, while a similar MSCI index tracking the rest of emerging markets has jumped 7% over the same period. The same difference has emerged in bond markets, with Chinese debt returning less than 1%, compared with a 4% return for emerging markets as a whole.

Chinese stock valuations have become so low that there is plenty of room for recovery if sentiment stabilizes. Authorities signaled their intention to boost growth last week, with the central bank unexpectedly cutting a key policy rate. The government may unleash more pro-growth measures ahead of the National Party Congress expected later this year as President Xi Jinping seeks a third term.

Meanwhile, doubts are growing about the rest of the emerging markets.

The dollar has started to strengthen again from the lows it hit earlier this month, slowing foreign capital inflows to developing countries as a whole. Financial conditions are also tightening globally as central banks raise interest rates to contain inflation, weighing on growth prospects for many emerging economies. Close ties to the slowing US economy are also expected to drag on performance.

Emerging markets outside China have held up “largely because of perhaps over-optimism that the US economy is not going to slow as much as previously expected and that the Fed will not need to tighten monetary policy as much,” said David Chao, strategist of Invesco’s Hong Kong global market, which oversaw $1.45 trillion in July. “I’m not sure I buy this.”

In Asia, South Korea and Taiwan look particularly vulnerable as a slowdown in spending by their biggest customers, such as Apple Inc., underscores a slowdown in demand for chips, whose makers are index heavyweights.

That said, some sectors in emerging markets outside China may continue to outperform, with Indonesia and Brazil supported by energy stocks and India by financials, which are thriving amid a revival in domestic demand.

The gap between China and other emerging markets will also begin to close as the slowdown in the world’s second-largest economy spreads to its closest trading partners, such as Korea and Malaysia.

“In the long run, whether emerging markets can ‘decouple’ from China’s slowdown and outperform depends on their initial valuations and whether they have drivers of growth other than commodity exports to build Chinese homes and infrastructure,” he said. Ian Samson, fund manager at Fidelity International in Hong Kong;