Should MSCI & Russell FTSE China Allocation Gains Have Been Delayed During Trade War?

After months of being told that a deal with China was likely, a trade war has erupted after President Donald Trump lifted selected tariffs to 25% from 10% on $200 billion worth of goods and pledged that tariffs on more goods would be coming on potentially $300 billion more. China retaliated by increasing tariffs on U.S. goods as well.

While the trade war almost undeniably will hurt China far more than it will hurt the United States, there are consumers, farmers, manufacturers and employers that all face tougher times until these trade disputes are worked out. It also seems that the public should now assume that a trade deal is farther away than it is closer to fruition.

There is an interesting allocation change that is set to take place that may offer some magical support to China in how it evaluates its own valuations and financial market impact. Two of the largest global index providers are MSCI and FTSE Russell. Both index-runners are soon to increase their international exposure to Chinese listed companies that are listed on the domestic exchanges. This is going to act as a boost to the so-called A shares that international asset managers will be forced to buy into if they want to keep up with the various index benchmarks they follow.

At the current time, with a trade war affecting the valuations of many companies and sectors around the world, should MSCI and Russell FTSE have delayed the increased allocations until there are nontraditional market forces at work? The runners of international indexes would certainly not want to appear to have a political stance nor a national favoritism to be perceived, but they also don’t want mechanical allocations to punish investors who are forced to have exposure to their indexes.

MSCI is set to raise the allocation of its A shares in multiple indexes, and this is actually the first of three allocation increases. By the time the proposed allocations are all final and completed, the A shares will make up by about 3.3% of the MSCI Emerging Markets Index by the end of 2019 — or increasing the inclusion factor from 5% to 20% per its own site info. MSCI also noted that in the event of full inclusion, China equities would exceed 40% of the MSCI Emerging Markets Index.

Before just thinking that this would be a move to hurt China, note that it might have been considered a move to protect the global financial managers and their investors from having larger weightings to a country dealing with nontraditional market forces. A trade war is far from a traditional market risk. There was close to $1.9 trillion in invested assets in mid-May that tracked the MSCI Emerging Markets Index, so somewhere around $50 billion in new funds are set to be allocated into China’s A-shares from that index alone.

The allocation changes in the FTSE Russell indexes to China’s A shares are set to happen in June.

China already has the largest weighting in emerging market indexes due to its vast size, and an increase of this magnitude might prevent investors from having to take on such exposure in what already has felt like a volatile time. The weightings are frequently more than 30% of portfolios, something that traditional ETF investors have had to stomach when they believed they were investing all over the world rather than so much being allocated to China.

China’s efforts to open their local markets to foreign investors have been years in the making, but even with concessions there are many exclusions and issues for foreign investors that local investors and local institutions are given. Market access, liquidity, use of derivatives, being able to withdraw funds from the country, differing settlement dates, market closures around holidays and ranking are all among those risks.

A blog post from MSCI on May 24 specifically pointed out that a further escalation of the U.S.-China trade war could have severe implications for the Chinese economy, with potential spillovers to other emerging market countries.

The Xtrackers Harvest CSI 300 China A-Shares ETF (NYSEARCA: ASHR) was up 2.1% at $26.29 as the MSCI influence on A shares was set to take effect. This exchange-traded fund was up above $29.00 at the start of May and was almost $31 at the start of April.

The iShares China Large-Cap ETF (NYSEARCA: FXI) was last seen up 1.1% at $40.35. This was almost $45 at the start of May and was nearly $46 at the beginning of April.

As proof of the impact of China on emerging markets as a whole, note that there is the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM), which sounds like it gives vast global exposure to emerging markets. The iShares description of the world’s largest U.S.-denominated emerging market trading vehicle offers three advantages for emerging market investors:

  1. Exposure to large and midsized companies in emerging markets
  2. Easy access to 800+ emerging market stocks
  3. Diversification internationally and seek long-term growth

The ETF has over $30 billion in assets, but five of the top 10 holdings are in China.

Retroacting decisions is never an easy effort, and there are instances where the effort might just mean more work with unknown ramifications. Trade wars are definitely not the normal market risks that investors are taking on.

Credit Suisse also showed how it views the China A share market strategy exposure running. It noted that (effective May 28) MSCI will officially increase the index inclusion factor of all China A Large Cap shares from 5% to 10% and add ChiNext Large Cap shares with a 10% inclusion factor. Including active and passive fund, $15 billion is estimated along with the May weight increase, and that on the completion of all three steps (in November 2019) a fund inflow of $50 billion is estimated.

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