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Key Points

  • Emerging market investing has grown in popularity over the last several decades, offering the potential for return and diversification.
  • Important emerging market equity indexes tracking those markets have similarly evolved. Most recently, MSCI is undergoing significant changes to the makeup of its key emerging market index.
  • This article explores the implications of these changes for investors, along with the economic backdrop of the countries involved – China, Saudi Arabia and Argentina.


Over the last 30 years, emerging market (EM) investing has evolved from niche to necessity. For most investors—largely institutional investors at first—EMs typically represented a very small allocation in a portfolio, but over time, investing in emerging markets grew as investors of all stripes recognized the potential for return enhancement and risk diversification. Although EMs can experience significant volatility, historically that risk has been rewarded: EMs have outperformed developed markets by more than 2.4% annually over the past 30 years.1

A critical event in this evolution has been the development of indexes that track stocks in the region, most importantly, the launch of the MSCI Emerging Markets (EM) Index in December 1987.2 The index tracks the stock markets in 24 emerging market countries with 1,136 constituents. But just as emerging markets are constantly evolving and changing, so are the indexes that track those markets. In 2019, the MSCI EM index is expected to increase its coverage to embrace more inclusions of China-A shares, which are traded in Shanghai and Shenzhen, as well as Saudi Arabia and Argentina, representing an approximate 6% index weight shift of the index’s total market. This could have crucial implications for investors who are considering whether to invest in a fund that tracks the index, or one attempting to outperform the index.

Upcoming changes to key MSCI indexes

The successful initial inclusion of Chinese A-shares into the MSCI EM index last year and a strong commitment by the Chinese regulators to improve market access by expanding the stock connect programs allowed more inclusion of A-shares this year. In March, MSCI announced its decision to increase the inclusion factor of A-shares from 5% to 20% in the MSCI EM index. There will be a three-step implementation process that begins in May, which will widen the breadth of the China A-shares exposure in the MSCI EM index.

In addition, MSCI will include 32 securities from the MSCI Saudi Arabia Index in the MSCI Emerging Markets Index, representing a weight of approximately 2.7% of the index on a pro forma basis following a two‐step inclusion process in May and August 2019.

After the country’s downgrade to frontier market status in 2009, Argentina will finally be reclassified as an emerging market country to be included in the MSCI EM Index in May. Its weight in the MSCI EM Index is expected to be roughly 0.33% by the end of this year.

What does inclusion mean for EM investors?

While most investors have focused on the impact of the upcoming inclusions on the MSCI EM Index, the changes could also affect country and regional indexes. For example, the A-shares exposure in the MSCI China Index allocation will increase from 2.3% to 10.4% and from 0.8% to 4.0% in the MSCI All Country Asia ex Japan Index.3

Although the EM index continues to provide investors access to the broader EM market,

China A-Shares and the Hong Kong-traded H shares are set to have a combined index weight of more than 40% after full inclusion of A-shares. This underscores how taking a view on China could become more and more important. Just as investors break out U.S. allocations from other developed markets, investors should consider treating China and the rest of EM as two separate allocations as the behavior and investment implication for the Chinese market can be fundamentally different from other EM countries.

Figure 1

Figure 1

Source: MSCI, China would comprise 31.3% of the MSCI Emerging Markets Index at 5% inclusion as of August 2018 (left panel). At a hypothetical 100% inclusion, China would comprise 42% of the index, based on the market capitalization as of August 2018.

Country recap

We remain positive on the outlook for emerging markets, but believe investors should be selective and focus on countries or regions with strong fundamentals.

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A key turnaround moment

Policy stimulus, improved macro data, and the easing of U.S.-China trade tensions earlier this year led to a sharp performance rebound in Chinese market this year. Even with the return of trade uncertainty, Chinese A shares have outperformed all other EM assets this year with a 22.8% YTD gain, while a majority of the best performing stocks in the MSCI EM Index this year are Chinese companies.4

The economic turnaround is visible in the recent macro data: China’s Caixin services PMI materially surprised to the upside in March, rising more than three points to 54.4 vs. 52.3 estimated, pointing to improvement in the sector that now represents the largest share of China’s GDP (Figure 2). We are increasingly confident that Chinese growth is likely to reaccelerate from the second quarter onward, as the credit impulse turns positive and fiscal stimulus gains traction.

Foreign flows into Chinese equities rose significantly in 2018 as a result of the MSCI EM Index inclusion, and the additional China A inclusions this year could bring more inflows and liquidity as global investors rebalance portfolios and interest in China grows.

To be sure, potential risks could derail the Chinese market: Chinese policy makers could mitigate the extent of stimulus measures in the next few months given the recent economic improvement; Chinese stocks are vulnerable to negative market reactions as trade conflicts remain unresolved. We expect trade-related volatility to continue until the G20 Summit on June 28-29 at a minimum while our base case is for continued U.S.-China tensions in the years ahead.

Figure 2: Services surprise: China PMIs

Figure 2

Source: Thomson Reuters Datastream and BlackRock Investment Institute. May 01, 2019.

Not just an energy story

Saudi Arabian stocks gained 16% in 2018 while the rest of EM countries tumbled. In 2019, Saudi Arabia’s equity market strength has continued, with MSCI Saudi Arabia outperforming the MSCI EM Index by seven percentage points.5 The inclusion offers investors with a diversifying exposure to Saudi Arabia’s market. Note that before the inclusion, only 1% of the Saudi stock market was owned by foreign investors, compared to the 11% average of other emerging market countries.6

While the energy sector contributes heavily to the Saudi Arabia economy, the sector holds just a 0.7% weight in the MSCI Saudi Arabia Index given that the state owned Aramco remains unlisted. As the Saudi government privatized many industries, its stock market is now largely made up of two sectors—financials and materials. More than half of the YTD performance of the MSCI Saudi Arabian Index can be attributed to a 31% gain in the financial sector, which makes up 41% of the index. Financials shares have benefited from a rising interest rate environment as the central bank (SAMA) raised benchmark interest rates through 2018, boosting net interest margin and return on equity expansion in the banking sector.

The initial MSCI inclusion in May could open the door for more foreign inflows into Saudi Arabia. However, potential risks include additional western sanctions against Saudi Arabia that could challenge economic activity in the country and impede its reform agenda. Separately, a decline in energy prices would impact the health of Saudi Arabia’s overall economy.

An alternative for EM investors

With more investors taking a view on China given its distinguished market size and performance drivers, emerging market exposures outside China could offer investors a unique opportunity to take advantage of the rest of EM growth.

The MSCI EM-ex China Index heavily focuses on emerging market countries in Asia, with Korea, Taiwan, and India making up roughly half of the index weight. We remain constructive on those EM Asian countries based on stable economic growth and fundamentals. Analysts estimated that emerging market countries outside China will have a combined earnings growth of 12.4% in the next 12 month.7 In addition, improved consumption and economic activity from Chinese stimulus could help provide more support to EM Asia exposures. Valuation is also more reasonable for the EM ex-China exposures, the price to earnings ratio is 12.8 vs. 12.1 for the MSCI EM index and 13.7 for the MSCI China index.8

For investors who want to maintain their current EM allocation to China with upcoming index weight changes, they could slowly increase their exposure to EM-ex China (Figure 3). After the full inclusion, investors could then add an additional 11% of EM-ex China exposures into their EM portfolios if they wanted the current allocation to China to remain unchanged.

Figure 3: Maintaining a steady weight of China in the index

Image 3

Source: BlackRock, as of May, 2019. The chart illustrates the amount of additional EM—ex China needed to maintain a constant allocation to China in emerging markets, based on different weightings of China in the MSCI EM Index. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

Uncertainty ahead

Despite large financial support from the International Monetary Fund, market volatility in Argentina remains elevated as concerns over the possibility of a deeper recession and record-breaking inflation grow. The country suffers from a large current account deficit (Figure 4) and economic growth recently contracted.

In addition to a bleak economic outlook, political uncertainty is likely to remain elevated ahead of the country’s general election in October. The worsening financial problems faced by the country could lead to a victory of the former leftist president Cristina Fernández de Kirchner as her support has grew stronger in the polls, surpassing current president Mauricio Macri, who remains the market favorite.

Figure 4: Argentina - Current Account Balance % of GDP

Figure 4

Source: Thomson Reuters, IMF World Economic Outlook, as of May 2019.

Christopher Dhanraj
Head of iShares Investment Strategy
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