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There’s nothing like a good, old trade war to cause stocks to sell off.
On Monday President Trump directed the U.S. Trade Representative to prepare 10% tariffs on $200 billion worth of Chinese exports to the United States. That followed the imposition of tariffs on $50 billion of Chinese goods. China’s audacity in matching that move apparently enraged the president, who quadrupled down on his original tariffs. Another round of tit-for-tat tariffs would cover almost all of the $500 billion worth of goods the U.S. imports from China every year.
Trump’s move may have pleased the basest of his base, but it threw markets for a loop. At Tuesday’s close, the Dow Jones Industrial Average had lost more than 600 points since last week, erasing all of 2018’s gains, while the S&P 500 Index also fell.
Slumping Shanghai
But Chinese stocks have really taken it on the chin. The Shanghai Composite index has lost 5.6% over the past four trading days and has fallen in seven of the past eight sessions. Tuesday’s close was the lowest in two years and it marked an 18.3% decline from its recent late-January high. That’s almost bear market territory. By contrast, the S&P 500 is only 4% below its late January all-time high.
Why do all these numbers matter? Because China is playing a bigger and bigger role in global and emerging markets indexes. So if you own an emerging markets stock fund (which I don’t because I think it’s a bad investment), the impending or actual trade war with China is hitting you in the pocketbook: The MSCI Emerging Markets Index ETF has lost 16% since its late-January high.
Last year, MSCI, whose benchmarks are tracked by $10 trillion in investor assets, decided to expand some of its indexes to include A-shares, stocks traded in mainland Chinese exchanges like Shanghai and Shenzhen. Previously, the emerging markets index tracked only shares traded in Hong Kong. The addition ultimately would increase China’s weighting in the index to 40%, from 26% before.
FTSE, another big index provider, has included A-shares since 2015. The largest emerging markets stock ETF, the Vanguard FTSE Emerging Markets ETF which follows the FTSE index, has 36% invested in China. (If you count Taiwan, sometimes considered part of “Greater China,” it’s 50%.)
Emerging-markets fallacies
But shouldn’t we want more exposure to China, the world’s second-largest economy, which is growing faster than almost every other major country?
Those are the two central fallacies in emerging market investing — that those countries’ stock returns mirror their faster GDP growth and that portfolios should ideally replicate countries’ percentages of global GDP or stock market valuation.
But like all quota systems, it misses the point that some markets perform much better than others over time.
Researchers Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School have developed the gold standard for measuring long-run comparative returns of global markets. They’ve long been skeptical of the notion that faster GDP growth translates into bigger stock market profits.
In fact, in the Credit Suisse 2018 Investment Returns Yearbook, they reported that an emerging markets stocks index returned 7.4% a year from 1900 through 2017 while a developed markets index earned 8.4% a year. So, a dollar invested in EM in 1900 was worth $4,367 in 2017 while a dollar invested in developed markets at the same time was worth $12,877 in 2017, almost triple the return.
Secular bear market
China, in particular, has done poorly. While other markets, including ours, have long surpassed their pre-financial crisis peaks, Shanghai has never topped its all-time high near 6,000 in 2007. That’s the definition of a secular bear market, which has now lasted 11 years.
Even recently, its performance has lagged. From the market low in February 2016 to the peak in January of this year, Shanghai gained 32%, while the stodgy old S&P 500 rallied 55%.
And yet this is the market the big indexers are loading up on? I don’t speak Chinese, so I’ll just say: Go figure.
In fact, Reuters reported that MSCI added 234 mainland Chinese stocks to its global and regional indexes on June 1 — just as trade tensions were heating up with the U.S. Timing is everything, and it can cut both ways.
Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.