Is China set to retake its emerging market crown from India?

Every investor knows sentiment can be a powerful driver of performance. But what many fail to realise is that the sentiment itself – and whether it is positive or negative – is relatively inconsequential. It is the change in sentiment that is the important part, with a slight shift in mood enough to power an asset class, index or equity in the opposite direction before many investors have even noticed it turn. 

For example, sentiment has been positive on India and negative on China for many years. However, this appears to be changing. China has outperformed India by more than 50 percentage points over the past year and is ahead over three years, too¹.

China’s revival just getting started 

This is a trend we think is far from over. Even after India’s recent underperformance, it remains the most expensive market in the world, trading on 22x forward earnings (18% higher than its 20-year average)² while earnings have recently been downgraded.  

The US’s threat to impose tariffs of up to 50% creates further uncertainty and any obstacle to growth could be punished severely when valuations are so high. This is not a market that is prepared for bad news.  

Compare that with China, where stimulus packages announced by the government last year are beginning to feed through to the real economy. Yet even after this year’s strong performance, it remains one of the world’s cheapest stock markets. 

Returns are determined by the price you pay 

You may still be tempted to favour India thanks to its strong demographic tailwind – it has a young and growing population, while Q2 economic growth came in at a massive 7.8%³. 

But if this is what you are basing your investment decisions on, allow me to refer you to the case of China in 2007, the year its growth rate peaked at a whopping 14.2%⁴.  

Back then, its GDP stood at $3.6trn. By 2024, it was $18.7trn⁵. Between 2010 and 2024, annual disposable income per person had more than tripled⁶. 

These are exactly the sort of trends that any top-down macroeconomic-focused investor would aim to benefit from. So how much would you have stood to make had you invested in the MSCI China index as these tailwinds were getting up to speed – say, October 2007 – and held up until the end of August this year?  

0.9% per annum⁷.  

That’s right. 0.9% per annum. Just to be clear, that is not the real return – the 0.9% is the nominal figure before inflation is taken into account. After inflation, the small positive turns into a negative. 

Admittedly, this is the return in the local currency; UK investors fared slightly better, with the pound falling against the yuan over this time. But still, annualised returns of 3.6%⁸ over almost 18 years are nothing to get excited about. 

The economy is not the stock market 

So why didn’t the long-term boom in the Chinese economy translate into a long-term boom for investors? The first point to remember is that the economy is not the stock market. While the stimulus measures enacted by the government in Beijing during the Global Financial Crisis helped to maintain China’s growth trajectory, a speculative bubble that began inflating in 2006 meant its stock market looked overvalued even before the downturn hit.  

As you’ve probably worked out, the peak in that speculative bubble occurred in October 2007. You could argue that we have cherry-picked this number and that the returns would look far more respectable had you invested a couple of months either side of this date. But this brings us to our second point – regardless of how fast an investment ends up growing, the price you pay for it is a major determinant of your returns. 

That’s why our SmartGARP stock-screening tool aims to find companies that are both growing faster than the market and are available at a cheaper price. It also helps to explain why, even though India is predicted to become the world’s third largest economy within three years, high valuations mean we see better opportunities elsewhere (and our weighting to the country is less than half that of the benchmark’s)⁹. 

Not every company in India is overvalued  

We do not dismiss India out of hand, and currently like refining, resources and infrastructure companies, as well as select opportunities in healthcare, tech and industrials. 

However, we are worried about its banks as these account for about 30% of the stock market’s profits – yet the credit cycle has already rolled over.  

When sentiment turns from positive to negative on this fully valued sector, the correction will be severe. So severe, in fact, that eventually the decline in share prices will surpass the decline in fundamentals and these stocks will become cheap once more. Even further along, these cheap stocks will begin to grow, and that’s when we could become interested once more.  

Whilst we accept that we can always be wrong, we respond to changes that are not reflected in share prices. We believe this approach offers some protection from human excesses and delivers good returns to investors over time.