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Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

So, Shani, a big day for you today.

Shani Jayamanne: Is it?

LaMonica: Yes. Priscilla, and as people remember, Priscilla is your dog, has a new dog sitter.

Jayamanne: Yeah. So, he can't be left alone. He's very much a COVID puppy. So, has a new dog sitter.

LaMonica: Yeah. And you showed me a picture that the dog sitter sent and he seemed to be quite happy.

Jayamanne: Yeah. She was just laying on the couch with him.

LaMonica: Yeah.

Jayamanne: How do I get this job?

LaMonica: I'm not sure. I mean, I don't think anyone's going to pay you to take care of your own dog.

Jayamanne: Yeah, that's true.

LaMonica: And it'd be a little strange if you were going over and taking care of other people's dogs. While, the dog sitter is at your house, right?

Jayamanne: That's true. That's true. I mean, I could take care of my dog and other dogs. Isn't that what dog sitters normally do?

LaMonica: Maybe. I don't know. I don't have a dog.

Jayamanne: Okay.

LaMonica: So, I'm not experienced with this. But why don't we move on to today's topic?

Jayamanne: Okay. So, today we're going to talk about China.

LaMonica: Yeah. And we're going to talk about a couple of different perspectives. So the first considers how intertwined our economy in Australia is with China and, of course, how intertwined the global economy is with China.

Jayamanne: And we're going to explore how a Chinese economic downturn could impact the rest of the world.

LaMonica: And the second perspective is China as an investment and whether we see it as an opportunity.

Jayamanne: So let's start with that first perspective. How an economic downturn could impact the rest of the world. And this is based off an article from Kate Lin who is based out of Morningstar's Hong Kong office.

LaMonica: And as people who are reading the paper or I guess reading our website know, China's economy isn't so hot at the moment. They have deflationary pressures, the depreciation of the won, and more widely known the struggling property sector that (indiscernible) Evergrande, and Country Garden.

Jayamanne: And broadly, she states that because of the size of China's economy and how deeply it penetrates, there are three main impacts of an economic downturn.

LaMonica: The first is a negative effect on global commodity exporters, which of course is especially important for us here in Australia. So if China experiences a downturn in the property sector, of course there are commodities and materials that go into these properties. This means that a downturn would continue to depress global commodities demand and of course commodity prices.

Jayamanne: And as investors, we're heavily invested in commodities and materials in Australia. The industry dominates the ASX alongside banking. And of course, Aussies have a strong sense of home bias. Basic materials make up 23.4% of the ASX 200. BHP is the top holding of the ASX 200 at 10.24%.

LaMonica: A couple of things have happened. The first is that there has been an unprecedented urbanization in China. You go back to 1980, 22% of the Chinese population lived in the city. In 2022, it's just under 65%. So you've had this huge migration with, of course, a huge population from the countryside into cities. Of course, those cities had to be built and those cities being built required steel and iron ore is required for steel.

Jayamanne: So we've had all this urbanization in China, which is slowing and almost stopping at this point given that huge swing, 45% of the population switching from rural to urban.

LaMonica: The other part of this is infrastructure to support a growing population and a population shifting into cities. And just to keep the economy going, there has been heavy infrastructure spending. But at this point on a per capita basis, China has reached Western levels. So while there still will be development of infrastructure, there isn't going to be this huge cyclical catch up that we've seen in China. So this is another factor that we need to consider.

Jayamanne: And if we look at what this means, a lot of the basic material commodities are inputs into construction and construction is pretty cyclical itself. You have investments into new buildings, new houses, et cetera. When the economy is doing well and people are comfortable spending and borrowing money. And then these projects get taken offline when the economy is doing really poorly or they get delayed until better conditions. This, of course, impacts commodities.

LaMonica: The second effect is the reshaping of trade deals. If there's subdued demand from China due to an economic downturn, that can be offset by other economies and sectors that need those commodities and raw materials.

Jayamanne: T. Rowe Price believes that producers of metals solely tied to housing construction could face pressure from China's slowing property development. They've also said that there could be a shift towards green energy infrastructure and that will lift demand for metal intensive exporters. So those include South America, Indonesia and South Africa.

LaMonica: As well as this, they see China offshoring lower value added factories and production to focus on products and sectors where they have a competitive advantage. So these lower value added productions will be moved to frontier markets in Asia.

Jayamanne: So what does that mean? It means that there will be more exports from frontier markets and a Chinese economic downturn would support other emerging markets.

LaMonica: The last effect of a Chinese economic downturn is a bit of a silver lining. The cheaper Chinese goods will help with the global inflation outlook. Although exports to China will impact us, we're seeing that China's exports won't suffer due to the current environment.

Jayamanne: We've seen the cost of living impact most of us. We're all looking for cheaper goods and services and China is known for that. So as global economies develop a preference for cheaper goods and services due to high inflation.

LaMonica: These cheaper goods will serve as a moderator to inflation. This would be supported by weaker Chinese currency, which makes the goods even more attractive to foreign economies.

Jayamanne: According to the National Bureau of Statistics of China, the Producer Price Index, which tracks the prices that factories charge wholesalers for products, it fell by 4.4% year on year in July 2023 and was down for a 10th consecutive month.

LaMonica: This declining PPI is indicative of an economic slowdown. But again, the falling prices of these products is buoying the economy due to inflation in the Western world.

Jayamanne: So onto our second perspective, is there an opportunity for investors here? We've interviewed Matt Wacher on the podcast before. He's CIO for Asia Pacific at Morningstar Investment Management. He says there's definitely a downturn in the Chinese economy.

LaMonica: He says that at Morningstar Investment Management, they view China as going through cycles. They don't think that the situation is going to last forever. So he believes that some of the valuations in China are quite compelling.

Jayamanne: He thinks that the U.S. aren't really going to be impacted by this Chinese downturn. Their economy is diversified and it's very large. He says that for investors that want to de-risk and reduce exposure to the Chinese downturn to be careful though, because the U.S. are sitting at unattractive valuations at the moment.

LaMonica: When we look at the Morningstar price to fair value of our coverage, we can see that the U.S. market is sitting at about fairly valued.

Jayamanne: So let's dive a little bit deeper into whether China is an opportunity.

LaMonica: We recently did an episode on Japan and the lessons that investors can learn from their story. One of these lessons is when to take advantage of opportunities, even if they might be a little uncomfortable.

Jayamanne: We mentioned that it's uncontroversial to say that taking an outsized position in Japan in the 20 years following 1989 would have made you a contrarian.

LaMonica: And being contrarian is hard because you lose the validation that comes from traveling with the herd. It is human nature to seek validation, especially as investing your hard earned money is an inherently emotional endeavor.

Jayamanne: Contrarian investors can be rewarded handsomely. So the Nikkei has outperformed the ASX 200. If you invested $100,000 in July of 2008, and $1,000 every month from there, you would have close to $450,000 from the Nikkei. An investment in the ASX would have given you $320,000.

LaMonica: The point is that purchasing assets at lower prices means that there's greater potential for returns and therefore less risk. This works out well if a quality asset is purchased. Quality was an issue with Japan. There were regulatory and market risks impacting Japanese companies. These risks led to uncertainty in cash flows.

Jayamanne: And so we're seeing the same questions that are being raised about China. There are regulatory differences between Western democracies and a political structure which puts the interest of the state above those of the individual and private property. The share market also suffers from a perceived lack of fairness with reports of rampant insider trading.

LaMonica: We need to look at these risks in the context of potential returns. And these risks may be muted by low valuation. China is one of the most undervalued regions according to our price to fair value indicators. When we spoke about Matt Wacher's thoughts, so Morningstar Investment Management has been taking positions in China.

Jayamanne: So investing in China would make you a contrarian. At a certain price, even a high risk investment may be worthwhile for an investor. Morningstar's fair value estimate helps investors understand whether a stock or a market is undervalued.

LaMonica: As we form a view of an overall market by taking the fair value of each share, we cover in that market and rolling them up to the country level. This is a bottom up way to assess a market that helps investors see past the current market price. Currently China is at a 0.70 price to fair value, indicating that Chinese shares in our coverage universe are undervalued by 30% in aggregate.

Jayamanne: Investing in China would fit into an investor's international equity exposure. And a level down from that, there are emerging market exposure. Investors have been wary of emerging markets in the past as they're not well researched or as saturated a market as U.S. or Australian equities. But it's for this exact reason that they're full of opportunity.

LaMonica: They've also been turned off from emerging markets because it can be time consuming, especially if the due diligence is done yourself. There are quite a few hurdles which you may face, such as different languages, accounting standards, access to information, and customs that can complicate relative investment valuations.

Jayamanne: The first signs of increased interest in investing in emerging markets was during the early 2000s. Investors saw that China was experiencing incredible growth and providing much more attractive returns as it was cementing its place as an economic powerhouse.

LaMonica: The short term returns were extremely attractive for investors. And from 2000 to 2009, the MSCI Emerging Markets Index net of dividends had an annualized return of 9.78% annually compared to the S&P 500, which returned a negative 0.95% annualized, and the MSCI World ex USA at 1.62%.

Jayamanne: There is a darker side to emerging markets investing though. If we look at the following decade from 2010 to 2019, the MSCI Emerging Markets Index returned 3.68%. World ex USA was 5.32% and S&P 500 was 13.56%. When we smooth out the returns like this, we're ignoring a particularly important consideration for emerging markets investing, and that's volatility. Between 1988 and 2019, emerging markets outperformed U.S. stocks by 34 percentage points or more per year four times. It also underperformed U.S. stocks by that same magnitude four times.

LaMonica: The extent of inclusion of emerging markets into your portfolio will depend on your risk capacity. Although emerging markets can provide investors with stellar returns, they require long time horizons to balance the short term volatility. They would also suit investors that are not heavily reliant on dividends as a source of income. Emerging market companies may have strong growth prospects, but the volatility of the regulatory, legislative, and competitive environment means that income, if any, is not as reliable.

Jayamanne: So let's talk about valuations. For emerging markets, we can get an indication from the price to earnings ratio or PE across ETFs. The MSCI World All Cap Index has an overall price to earnings ratio of 20.72, the iShares S&P 500 sits at 19.99, and the MSCI Emerging Markets Index sits at 14.2, and that's at the end of August.

LaMonica: On a relative basis, emerging markets are appearing cheaper than all other markets and especially the U.S. When we single out China, the iShares MSCI China ETF has a PE ratio of 12.61, and that's in mid-September.

Jayamanne: Regardless of the attractive valuations, we do understand why investors are wary. We champion investors understanding what they're invested in. This lends itself to confidence in your investments and less likely to demonstrate poor behavior as an investor.

LaMonica: And the collapse of developers like Country Garden is still fresh on our minds, and a huge focus is protectionist measures by President Xi, which has suffocated growth for Chinese-based multinationals. This aversion has meant foreign divestment from Chinese markets. Reuters reports that U.S.-based actively managed funds are close to their lowest allocation to Chinese equities in the past 10 years. The exposure of managers has fallen to the second percentile, where 100 is the previous peak weighting.

Jayamanne: But as we mentioned, contrarian investors and managers believe that the opportunity outweighs the risk. Morningstar Investment Management believes that China's disappointing economic indicators, including weaker growth, retail sales, and high-youth unemployment, has seen sentiment turn highly negative.

LaMonica: Chinese companies are also under-earning relative to history. Their thesis is that once there is stabilization in profits, Chinese markets will strengthen.

Jayamanne: Morningstar, head of multi-asset research, James Foot, says the balance between risk and return presently favors Chinese equities. This is due to highly attractive valuations, particularly among the Chinese tech names.

LaMonica: He adds that it's not all upside. Despite this attractive skew, there is a small chance of large losses that could stem from a material escalation in geopolitical conflict.

Jayamanne: So he suggests investors should consider this in their portfolio sizing and how much Chinese equity exposure they actually take on. Okay, so if you want to get exposure to China, how could you do it?

LaMonica: Well, first a little bit of a warning. So making a tactical asset allocation decision should not be done lightly. Regardless of the rationale, this is market timing. However, investors can take advantage of undervalued opportunities if they have liquidity. They are not deviating too far from their strategic asset allocation, and they have the time horizon required for the investments they are investing in.

Jayamanne: The Vanguard FTSE Emerging Markets Shares ETF with the ticker symbol VGE has been awarded a bronze medal from our analysts. As a quick refresher, the Morningstar Medalist rating provides investors with assessments of a product's ability to outperform its Morningstar category index after fees. It's the highest rating emerging markets ETF under our coverage, with the highest allocation to China.

LaMonica: Our analysts believe that VGE is a compelling option for providing cost-effective emerging market exposure in portfolios. It has a 30% exposure to China and exposure to other undervalued opportunities like Korea, which is currently trading at 0.78 price-to-fair value.

Jayamanne: This index provides access to a broad portfolio spread across the entire market cap spectrum from 24 emerging market economies. Our analysts believe that it effectively diversifies stock specific risks by holding over 4,000 stocks, which should mitigate the impact of the worst performing firms.

LaMonica: Investors that have a long timeline and are agnostic on dividends may decide to invest in currently unloved China, although some active managers are divesting, contrarian investors think that the risk is worth the potential return.

So there we have it Shani, our episode on China. So certainly investors that want to take on a little risk and be a contrarian might be interested in the opportunity. Thank you guys very much for listening. We really appreciate it. We would also appreciate any questions or comments you can add in the podcast app.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)