China has been the dominant theme in emerging markets for 20 years. Now, along with India, it is breaking away from the BRICs group – just as India is diverging from China. Fiona Rintoul reports.
One word dominates contemporary conversations about emerging markets: China. And in some ways, that one word sums up the past two decades of emerging markets – certainly the past decade.
“The start of the gradual opening up of China’s domestic equity and bond markets, and their subsequent inclusion in global emerging indices, is to be seen as a major feature of this decade,” says Peter Elam Håkansson, chairman of East Capital.
Twenty years ago, when emerging markets began their journey into the mainstream, China was not the first country on everyone’s lips. China B-shares entered the MSCI EM index in 1996. In 2017, China became the largest component, when it overtook South Korea with an index weight of 15.9%.
Today China accounts for a whopping one-third of the index – a higher proportion than previous index leaders – and the trajectory can only be upwards. MSCI’s three-step increase in the index inclusion factor for large-cap China A-shares and its introduction of mid-cap China A-shares will almost certainly be followed by further expansion.
Does this domination create a problem? It certainly poses questions as to the best way to invest in emerging markets. They are no longer a homogenous group – if they ever were – and the days of BRIC (Brazil, Russia, India, China) are long gone.
“India and China have very much separated themselves from Brazil and Russia, and Asia has separated itself from Latin America in terms of performance,” says Danny Dolan, managing director at China Post Global. “Political and economic stability are a prerequisite for economic performance.”
As a result, Dolan increasingly sees investors looking for single-country or single-region exposure, rather than global emerging markets. As China continues to open and perhaps moves towards 50% of the index, emerging markets ex-China may become a designation just as Asia-Pacific ex Japan has been for some time.
In any case, the China obsession is not always about China itself. The country is such a big topic in emerging markets partly because a lot of other emerging markets are linked to what happens in China.
“Most EMs export to China,” says Gergely Majoros, a member of the investment committee at Carmignac. “Some countries sell raw materials to China; others sell technological components.”
The rise of China itself also illustrates the fast-moving nature of emerging markets. The past decade “belonged to China”, observes Håkansson, as the country experienced “an uninterrupted transition from a quite basic industrial manufacturing and exporting nation into the leading digitalised economy of today with a strong domestic market”.
Stealing China’s thunder
The story of the next decade may be a different one. Majoros notes that the top ten companies in the MSCI EM equity index today have “nothing to do with the top ten positions ten years ago”.
It is Chinese tech companies, such as Tencent and Alibaba, that have delivered great performance in recent years, not, say, Gazprom. Financials and information technology are the top sectors in the MSCI EM equity index, with energy at below 10%. It would be entirely wrong to suggest that the Chinese tech boom has run its course – China’s aim now is to overtake the US as the largest tech market in the world – but just as China eclipsed Russia and Brazil in the 2010s, other markets may steal some of China’s thunder in the 2020s.
“In the long term, India has better demographics than China,” says Majoros, adding that India is one of the few emerging markets that is not much involved with China. “It’s more of a closed economy dominated by a domestic dynamic.”
Meanwhile, the inclusion of Saudi Arabian stocks in the MSCI EM equity index from June 2019 marks another new departure for emerging markets. At the time of writing, the IPO of Aramco, the state-owned Saudi oil company, looks like it might overtake Alibaba’s IPO on the New York Stock Exchange in 2014 as the largest global IPO ever.
“A bit ironic is that it represents the old natural resource-based economy and not the new tech sector that is nowadays more characteristic of the emerging markets space,” says Håkansson.
Ironic – and kind of typical for emerging markets. Fund managers need twinkle toes to keep up with these oft-times capricious markets where it is wise to expect the unexpected. This was perhaps never truer than during the difficult past decade, which James Johnstone, co-head of the emerging and frontier markets team at RWC, describes as “a fallow period for EM stock markets”, when, even within the juggernaut of China, GDP growth didn’t necessarily translate into returns.
“You needed good stock selection,” says Johnstone. “There was a big difference between the banks and telecoms that China sold you and having the opportunity to buy Tencent.”
Style, too, played a strong role in returns over the past decade, with quality, growth and momentum outperforming value. MSCI Growth was up 55% from the start of 2010 to October 2019, while the MSCI EM Index was up around 35% over the same period.
“Post the global financial crisis, where investors have stayed invested in emerging markets, they have been relatively risk-averse, seeking perceived certainty and visibility of earnings and pockets of growth,” says Sam Bentley, client portfolio manager at Eastspring Investments. “They have been prepared to pay very high prices for these sorts of stocks.”
It’s also worth remembering that what applies to equity investments does not necessarily apply to bond investments. “From a bond perspective, we see a lot more opportunities in Latin America and Eastern Europe,” says Majoros.
Even on the equity side, it’s not as if there aren’t good companies in Latin America. There are. In Russia and Eastern Europe, too, where a significant macro slowdown in the face of the euro crisis and disputes over Crimea and Donbass derailed the growth trajectory, Håkansson has seen higher growth levels over the past few years.
“Interestingly, this has been led by Poland and the Polish government’s focus on stimulating families’ purchasing power with various benefit payment schemes,” he says. “Romania has also been delivering strong growth numbers, helped by their inclusion into the EU in 2007.”
Very light exposure
As we move into a new decade, the question is whether emerging markets can deliver for investors – and if so, where the returns will come from. With China playing such a pivotal role in emerging markets, the resolution of the US-China trade dispute is crucial. Almost everyone agrees that this is unlikely to happen until after the 2020 US presidential election (Donald Trump said as much in London recently) but that some form of progress is then likely, regardless of who wins the election.
“It’s in the US’s interest and in China’s,” says Dolan. “iPhones and Xboxes are made in China, like many other products of US companies manufactured in China or with Chinese components.”
But even then, the problem will not be solved. For the trade war is essentially a skirmish in a gigantic, ongoing tussle between two superpowers for global dominance.
“China wants to overtake the US as the largest economy in the world,” says Dolan. “That’s fundamentally what the trade war has been about.”
Be that as it may, some of the numbers around emerging markets remain compelling. Johnstone notes that these markets have 65% of the world population and just 10% of the index. “Most investors’ exposure is still very light,” he says.
China certainly seems to be in investors’ sights despite the trade war – and the unrest in Hong Kong. A recent survey conducted by the Economist Intelligence Unit (EIU) found that more than 80% of investors plan to either “significantly or moderately” increase their allocation to Chinese investments over the next 12 months, with only 4% planning to reduce their exposure.
Johnstone, meanwhile, highlights the attractions of “corporate Russia”. He cites “impressive” companies such as Yandex, which is involved in autonomous vehicles as well as internet-related services, and Sberbank, noting the “long, deep educational backdrop” in Russia. There are risks, but they’re reflected in the valuations.
“We think the bulk of bad news has been priced into EM over last couple of years,” he says.
This could create opportunities, particularly for value investors. According to Bentley, global emerging market equities are trading cheaper than average at the headline level today and significantly cheaper than developed markets.
“Investor behavioural biases have driven stock dispersion between cheap and expensive stocks in EM to around two standard deviations, which offers disciplined value investors in EM a rare opportunity to capture outsized returns both in absolute and relative terms from here,” he says.
There’s something else too. Turmoil in developed markets has made the risks in emerging markets appear less potent. This is partly about politics, but not exclusively. It’s also about corporate probity.
“VW was not a Nigerian car company,” says Johnstone.
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