UNLOCKING GROWTH: EMERGING MARKETS BEYOND CHINA

When it comes to passive investment into EM, China has a large gravitational weight. It makes up almost a third of the MSCI EM Index (up from 20% a decade ago), and more than half of the index’s 1,335 names.¹ Yet looking at China’s significance in global markets, it makes up just over 3% of the MSCI All Country World Index.²

At the same time as China’s significance as a part of EM has risen, its growth has been challenged by various factors, including structural transitions taking place in the economy and regulatory crackdowns. China’s share of US imports has shrunk to less than 15% as trade tensions between the two nations continue to simmer, while its share of working age population has been declining since 2010.³

In the shorter term, Chinese consumers continue to be cautious and hold on to a greater proportion of savings in the post-pandemic era, while the jury is still out on whether a host of government stimulus measures will be enough to reverse the downturn in its property market.

While these challenges may well create investment opportunities in time, it suggests China may need to be viewed in a different way by investors – and potentially segmented from the rest of EM, so investors can dial their exposure up or down depending on the risks. Treating the two regions separately may also reduce volatility - according to March 2023 BlackRock data, more than 50% of the MSCI EM Index’s volatility was attributable to China, up from 40% five years before.

Emerging market economies are positioned to benefit from some of the key ‘mega forces’ driving the lion’s share of growth opportunities in today’s investment landscape. The most dominant of these forces in recent months has been artificial intelligence, where Taiwan is a leader, with almost 15% of its GDP coming from technology and the locally-headquartered Taiwan Semiconductor Manufacturing Company currently the world’s largest producer of semiconductor chips.⁴

With geopolitical fragmentation on the rise and the global economy splitting into competing blocs, markets such as commodity-rich Brazil - with its valuable resources and supply inputs, as well as a diverse export base across Asia, Europe and the Americas - are well-positioned to benefit. We think demographic change will also play a role in long-term growth as markets with younger populations claim an advantage, and with India set to overtake China by 2030 in terms of the percentage of its total population that’s working age, we expect demographics to act as a tailwind for the region.⁵

India vs China – projected working age populations

Looking at the economies that make up the EM ex China index as a whole, while they garner around 70% of their revenue from other EM markets (including China), the slowdown of growth in China has been somewhat of a positive force for these economies. Disinflationary forces have meant central bank authorities are more inclined to cut interest rates, in comparison to developed markets where rate cuts may still be months off.

This combination of positive macro forces has been reflected in the strong performance of the MSCI EM ex China Index, which returned over 15% in the year to May 2024, compared to around 12% for the broad EM index.⁶ Longer term, EM ex China has also outperformed broader EM, returning 6.5% for the five years to May versus 3.5% for broader EM.⁷

Over this period of strong returns, we’ve also seen investors voting with their feet when it comes to investing in emerging markets beyond China. In the US, iShares’ EM ex China ETF has seen more than US$12 billion cumulative flows since 2020. For the year to date, US flows to EM ex China are at 91% of the levels of broad EM flows.⁸

A modular approach that splits EM and China allocations allows investors to more nimbly pivot as tactical opportunities arise. One option is to replace the traditional EM exposure with a proportionate combination of China and EM ex China exposures⁹, which resembles the broader EM index but provides a ‘lever’ to over- or under-weight China based on the market outlook. Using ETFs as building blocks, it’s easy to take this approach while keeping portfolio costs low, and taking advantage of the liquidity of the ETF structure to respond rapidly to market events.

Depending on your own investment views, it’s possible to adjust and blend your allocation to EM economies through a combination of broad EM, EM ex China, Chinese equities and EM fixed income. With macro forces likely to lead to decidedly different outcomes for China versus the rest of EM, we believe having the ability to be more dynamic and selective with opportunities across these markets could be valuable.