American equity markets outperformed foreign equity markets for the ten years ended 2021. For the last year and a half, we are seeing early signs that a shift may be occurring. At NPP, we have a small position in international equities and that may grow over time. We especially like emerging market ("EM") stocks. A decade plus of underperformance has made emerging market stocks look very reasonable, even after adjusting for the inherent risks in less-developed markets. Many emerging markets have good demographics and growing economies. However, we are not as optimistic about the largest emerging market, China.
NPP tries to avoid Chinese equities or exchange-traded funds ("ETFs") that own Chinese equities and focus on EM ex-China exposure. We do not believe China is investable for a variety of reasons. The current economic war between the United States and China means the rules could change at any time. A change in priorities from Chairman Xi and the communist leadership could see the value and profitability of sectors or companies evaporate overnight. This has happened to many Chinese internet companies including Alibaba. In 2020, China halted the initial public offering of Alibaba subsidiary Ant Group and launched antitrust investigations into Alibaba that sent its stock and that of other Chinese internet companies plummeting.
Additionally, China is a rapidly aging country, and it has started to depopulate. It is no longer an engine of economic growth. While economic growth does not ensure rising equity markets, it is a lot easier for profits and equity markets to rise when the economy is booming. In addition, NPP and many investors believe China is in the middle of a large real estate bubble. Much of the population’s wealth is tied up in real estate. Falling real estate prices should hamper consumer spending growth.
A concern NPP has with many emerging market investment vehicles is that China usually comprises about 25-35% of most broad indices. Buying most emerging market equity funds requires having a large position in China. Fortunately, there are exchange-traded funds that allow investors to gain exposure to emerging markets excluding Chinese equities and NPP has added them in our clients' portfolios.
This isn’t to say investors do not have exposure to China. Many multinational companies that we own in client portfolios have sales and/or production facilities in China. There is also limited exposure for many investors in Chinese government debt via ETFs. This bothers us much less than stock ownership. We think it is less likely that China will default on its government debt. Access to debt markets still matters to the regime. Defaulting on sovereign debt would greatly reduce China’s access to external capital if not shut it out of these markets indefinitely. Finally, the exposure of emerging market bond ETFs to China is less than five percent which leaves investors with limited exposure to China.
In our opinion, Chinese stocks offer too much risk and not enough reward. We believe there are benefits in owning a small position in emerging markets ex-China equities for growth and diversification. Growth rates, demographics and valuations make them attractive if you are patient and can handle the volatility.