Emerging Markets ex. China

The idea that there is a non-China EM that can dance to its own tune is absolutely wrong. EM is highly responsive to Chinese growth, and that responsiveness has risen over time. For example, per a BLK econometric model, a 1% shock to Chinese GDP would move the rest of EM by 1% over the following 12 months, this is up from 0.7% measured five years ago. Having said that, not all Chinese shocks are created equal. Shocks stemming from the services sector, manufacturing, exports, infrastructure, etc. will impact different emerging markets based on a variety of factors, such as if the EM is an exporter of commodities, whether the EM is a manufacturing country, and what is their proximity or closeness to the Chinese supply chain, etc. This differentiated impact needs to be understood to source alpha opportunities.

Chinese shocks on the rest of EM can at times be played more efficiently elsewhere, especially when looking at some corporate state-owned enterprises or sovereigns that have a better creditworthiness or value proposition.

Chinese shocks on the rest of EM are also not linear. For example, today’s China slowdown is proving to be a deflationary or disinflationary force on other emerging markets, this boosts the attractiveness of EM duration through the capability for EMs to ease monetary policy.

So, while China matters to the broader EM picture, emerging markets stay idiosyncratic. It remains necessary to understand the source and impact of these Chinese links when thinking through security selection.

China matters from a market structure perspective in Asia. When thinking about regional markets in Asian credit, China is close to 40% of the market, when thinking about local currency markets, it could be between 40 to 50%. Two main forces driving how investors are viewing the opportunity set for China are the macroeconomic outlook and geopolitical effects, specifically when thinking about it from a broader Asian lens.

Across public markets, there has been less of a concern of “avoiding China”, though we are seeing some reductions in allocations and cases of index providers shifting from Asia ex. Japan to broader Asia Pacific indexes to diversify away, but we have not seen the formalization of Asia ex. China as a concept. In private markets, we are of the mindset that taking a long-term view matters, hence policy becomes quite a critical component in underwriting. We have seen more of a shift and slowdown in investor sentiment given illiquidity requiring harder decision making, and subsequently there have been some investor moves made to reduce exposure and diversify away from China, accelerating the conversation of Asia ex-China allocations. 

China has a very large gravitational weight. It accounts for approximately one-third of the MSCI EM index $7Tn market cap, and with approximately 750 names¹, nearly half of the stocks within the index. If we remove China from the EM index, we are essentially looking at only half of the companies in the current index and removing six of the largest 10 names, so it is not a decision to be taken lightly.

We see investors considering the idea of EM ex-China for two reasons, relative performance and allocation trends.

Looking back over the last three years, there is no doubt that China has underperformed relative to other emerging markets and the broader global equity market index. On a three-year basis, MSCI China generated -~10% annualized returns, while MSCI ACWI generated +~10% annualized, and broader emerging markets generated +~1% annualized². This underperformance has caught investor attention and underneath that, structural transitions driven predominantly from the real estate market and regulatory crackdowns are causing short-term pain.

With regards to allocations, we have seen investors make similar exclusions in other geographies, such as the extraction of the UK from the EU or Asia ex-Japan allocations. These conversations have been happening for a while, but with geopolitical tensions coming front and center in the US, we see investors wanting to either avoid China entirely or think about it in a different way. Given the relative underperformance in recent years, investors do not see the risk-reward trade-off, making it an easy conversation for investors to steer away. Across other regions, the conversation on China becomes more varied based on geopolitical standing.

Our view is if we purely exclude China out of the EM universe, it does eliminate some element of breadth, but could provide opportunity to better identify China shocks as a source of alpha generation. The China shock remains regardless of whether it is in the investment universe or not, our view is the shocks are here to stay and will be relevant across most portfolios for EM and DM.

The world is changing, and some of the biggest drivers of returns and capital flows into emerging markets will be different in the next five to ten years versus what we have seen since China joined the WTO just over 20 years ago. As supply chains get reorganized, we do expect a broader base of countries involved compared to the narrow globalization trend of the past 20 years that primarily benefited China. Separating the winners from the losers in this environment will be increasingly important, which we think should favor active management across both country and security selection.

We remain underweight China in our tactical portfolio and although valuation levels are attractive at an aggregate level, fundamentals are clearly deteriorating. Negative sentiment driven by geopolitical tensions are exacerbated by overall fund flows, with both international and retail trending negative. Specifically, we continue to be negative on real estate given the regulatory risk. At a high frequency level through some of the alternative data that we track (foot traffic, transit information, online activity), year-over-year we see alcohol sales are performing better, while demand for luxury goods is down. This gives us a sense that the consumer sentiment is somewhat negative, and we are subsequently underweighting the consumer sector. Two areas we remain constructive are across selective technology exposures, especially companies linked to climate-oriented technology which are enhanced by the excitement and structural support from the government, as well as state owned enterprises, which although not the most historically profitable, are receiving support currently.

A benefit of active management in a market as large as China is that there will be opportunities for selection, especially considering depressed valuation across the number of sectors that we see today. That said, we would agree it is tough on the ground currently, especially in the real estate markets, and activity levels are quite depressed, so we are underweight China.

In terms of strategic allocation, looking across the whole of global emerging markets over the next three to five years, we do think this theme of the “world of three”, where we see a block aligned with the West, a block aligned with China, and the others, “the neutrals”, persists. There are huge opportunities in the space for those neutrals, or the “transactional 25, aka T25”, as people are calling them, and we see increasing pools of capital from both the West and China competing for resources in those markets. This opportunity represents 50% to 60% of the GEM index in those T25 markets and roughly 45% of the world's population.

Additionally, several emerging market countries are positioning themselves to better harness natural resources, many of which are crucial inputs into the energy transition, such as nickel and steel in Indonesia and lithium in China and Argentina. Other countries like South Korea are benefitting from supply chain diversification, which has been increasing its market share as the hub for battery memory supply chain increases. Lastly, India is a good example of a country increasing its service exports through chemicals and industrial manufacturing processes, driving demand as more small and mid-sized companies across industries are integrating remote labor into their operating model. We see larger market share shifts being formed as different political blocs decide where they want to source their resources.

The cyclical weakness highlighted by our equity colleagues is also being reflected in our fixed income portfolios. Aside from the regulatory shifts, political uncertainty, and overleverage across certain sectors, there is a payback from an extreme amount of market share gains that China accrued since COVID which are now being reversed. We see a weakness in the currency driven by both supply and demand of dollars, and we are underweight CNY as a result. When we look at the balance of payments of China, we are seeing reduced resources and an increase in demand, a deficit that is developing by a policy induced weakness. Chinese government bonds in the local market are going to be helped by any form of stimulus that is likely to come from the monetary side, however, valuations relative to international interest rates are not appealing as China looks quite rich, especially compared to the developed world.

On the macroeconomic front, our view is positive considering the combination of slowing growth and more restrained fiscal policy coming to somewhat of a rescue which becomes a conducive environment for fixed income investors from an onshore market standpoint. Interest rate differentials will continue to impact currency, and we expect there is some room to run before this rate differential stabilizes, which will be a function of market pricing. Given the regulatory tightening across technology, education, credit markets, and real estate which has been most pronounced, we have seen a very significant default cycle that has led to a lot of noise through headlines and resulted in portfolio losses. In terms of the onshore market today, real estate as a sector is a rather insignificant contribution to the total market size, in the low-single digits range. Given this and the broader backdrop on the macro front, we think there is opportunity in looking at China.

We expect rates will be lower for longer in China. Given the restrained fiscal impulse and L-shape growth trajectory, we still think bonds remain reasonably well supported, though currency investing becomes difficult for offshore investors. Across corporates, we are seeing significant dispersion in terms of performance when bifurcating the market into four parts: state owned enterprises and government linked entities, financials, investment grade private corporates, and high yield private corporates. The first three categories are performing, with state owned enterprises having a strong 2023 and continuing to be well supported with low spread volatility. We do expect some noise to persist surrounding local government financing vehicles, but considering the direct linkages to the banking system, the government is trying to resolve these issues through potential debt swaps and other restructuring mechanisms. 

Across financials, the banking system continues to be relatively well supported, senior through to subordinate structures continue to do reasonably with a low spread wall. Where we do have concern is out the credit curve and into high yield. For real estate specifically, the lack of market activity down between 30% to 35% year-over-year does not instill confidence for investors to take exposures and risk in the sector, specifically across smaller and mid-sized private enterprises. Within the broader corporate sector, slower growth is impacting the smaller to mid-sized corporates, in terms of both availability of credit, as well as the ability to service debt. Capex remains generally weaker, affected by a combination of the soft sentiment onshore towards consumption and the payback from an export standpoint given the market share that China had gained between 2020 and 2023.