The Emerging Markets Equities Podcast: EM ex China — Finding opportunities in an overlooked market

Nick Robinson: Hello, everybody and welcome to the abrdn Emerging Markets Equity Podcast, I'm Nick Robinson from the EM Equity team.

In this podcast series, we explore the factors that underpin our thinking on emerging markets, from key individuals to evolving trends, we seek to answer the five W's: the Who, What, Where, When, and Why, that are shaping investment opportunities in the region.

In this podcast series so far, we spent a lot of time talking about China. And that's for good reason in that today, China is over a third of the emerging markets benchmark, and it's by far the largest country. However, China is still underrepresented in the benchmark relative to the size of the companies in the investable universe, as the onshore A-share market, the weighting is suppressed by the MSCI.

Over time, as the market matures and MSCI gains confidence in it, in terms of liquidity and capital flows, this weighting is likely to be adjusted upwards such with China could be half of the overall benchmark. And that's a huge weighting for a market which really divides opinions of many investors. Some like us see China as an incredibly exciting and innovative country, which will soon be the leading global power with world leading companies in high tech industries like renewables. Others, however, are more circumspect and see the continued geopolitical tensions and concerns, adding to risk which is already high, given the government's different political philosophy relative to the West. So given this debate, a recent trend we've seen is investors breaking out China from the rest of the their EM allocation and managing this China exposure separately. So today, I thought we'd talk about this new trend and discuss the implications of this for investors.

So to help me with this, today, I'm delighted to be joined by my colleague, Alex Smith. Alex is a product specialist on the Emerging Markets team based in London, and he's closely involved with developing products that meet our client’s needs. So is really well placed to see this new development in the market. Alex, welcome to the podcast. How you doing?

Alex: I'm great. Thanks, Nick. And it's an absolute pleasure to join you today.

Nick: So, let's get started. How about you give us a bit of background towards this trend that's been developing, and how do you think it's likely to evolve?

Alex: Yeah, thanks, Nick. And I think you've laid out that the issue there very clearly in that, you know, China's a huge part of EM, over 30%. And that's a rising, you know, a rising asset allocation, the indexing could hit 50%. And, and so in the last 12 months, we've had a lot of clients asking us about EMX China products. And we've seen a few papers come out in the sell side, you know, just generally referring to how dominant China's becoming in EM, and also the correlation between wider EM, and Chinese market performance. And that wasn't always the case. But certainly over 2021, the two have moved in tandem, and global indices are suppressing the amount of China exposure you get. So, you know, clients are increasingly wanting to make this decision, as you've said, about how much China to have themselves.

One comment I've seen is that this EMX allocation has been more than more talk than action today. And that is actually true. At the moment, we haven't seen vast influence. But actually, I think that could change quite quickly. And we've seen investors, at least a few, start to put their money where their mouth is with institutional searches going out. And I actually think this trend, I'm quite excited about this. I think this trend could accelerate quite rapidly over the next couple of years, but particularly for sophisticated clients. And really, the reason I think in the short term, people are going to want to look at EMX China is because of the success of China products.

So as the A Share markets opened up, and there's been quite explosive growth in mutual funds, all China, which is onshore and offshore, and China A - the onshore market, people have bought these funds, it's a very attractive way to invest. And then you have it sitting alongside and an allocation to your, to your EM and you have two allocations now, that potentially work in tandem, move in tandem. So, separating out China will allow you to manage your risk better and to deal with an issue potentially you have from investing directly in China.

You know, in terms of excluding China. Again, we have seen clients ask us and certainly, you know, in the US it's an issue in particular, where the geopolitical tensions are higher, less so in other regions. But I think for that to become a major driver of EMX allocations, there needs to be a change, a step change in US policy, you know, it will be an intensification of what some people have called this financial Cold War. That could happen. But I think that the short-term driver has been this this growth in, in China allocations, that's given sophisticated investors a risk, a risk issue in their portfolios. And given that China offers some very attractive investment opportunities, particularly with growing domestic consumption. If you're, if you're a client looking to maximise returns for your, for your pensions etc, excluding China, I think it's not necessarily going to be a decision that maximises returns at the moment.

Nick: I mean, I think on this podcast previously, we've highlighted China's hugely important role in the renewable supply chain. We've highlighted the success and innovation of Chinese internet businesses, do you think investors can gain that exposure sufficiently elsewhere outside of China?

Alex: Yeah, I think that's a great question, Nick. I mean, I certainly for one, get the feeling many clients think, you know, they see China as being one of the most developed EMs and being home to all these exciting, innovative advanced companies, and the rest of EM being this kind of basket of commodity exporters and dirty industries. And I know, I can understand that, Chinese internet names grabbed a huge amount of attention and still do, because they grew so explosively after 2016. And since 2020, we've had the growth of renewable names, as you saying, again, exploding kind of onto the market, but actually, these trends, you know, the trends that are driving that growth in China is occurring across EM, digitalization and the push toward clean energy. These are growing global phenomenon. And the third thing you can get outside of China is growing domestic consumption, which is an attractive, very attractive way to invest for the long term. You know, we've seen ecommerce growing rapidly in Southeast Asia, in India, and in Latin America, and consumers in EM potentially using these digital channels to make certain purchases for the first time. So as their consumption grows and moves up the value chain, you'll find some of the higher end products being consumed via digital channels, so that they come via a digital channel for the first time. And that type of product comes through that channel for the first time. That's a really exciting investment trend.

And there's also opportunities in companies working towards clean energy solutions and lower carbon things, you know, grid upgrades that's occurring in India, a lot of investment into the grid, electrification, lots of exciting companies doing things in Latin America, and then lower carbon solutions for things like transport, substituting trucks, and using rail transportation instead.

And in terms of technology, and kind of exciting companies, you know, EMX China increasingly has world leaders, the Indian IT companies are one area, they can compete with any IT service company in the West. And I'm not really even mentioning the semiconductor giants in North Asia, but that will be part of the universe, ex-China. And those companies underpin, you know, kind of so much in our daily lives, and so much of economic growth. So there are some really exciting companies. I think the kicker for EMX China is the potential of countries like Brazil and India to develop and to develop at an accelerating rate. I was reading some papers from our research institute, actually. And they forecast consumer markets to grow by 17 trillion in EMX China over the next 30 years. So there are some really powerful investment trends going on.

Nick: Yeah, I think there's two points I'd make here. I mean, firstly, in a scenario where China, there's widespread exclusion of China from portfolios and separation of China and the West as economies, investors are going to have to look for structural growth elsewhere. And I mentioned the domestic consumption story. India really stands out, I would say, as a market where you can get that structural growth that's been occurring in China over the last few years. And you know, given the demographics in India, it has the potential over multi decades to be as, you know, as big and as to grow as and become as attractive as China as an investment destination as consumers in India increase their incomes and buy more goods, but also, you know, as I mentioned, if there's a scenario where China separated from the West, India is also an obvious destination as a manufacturing hub. So you know, you could definitely see in that scenario, those countries receiving more investment. But if China's growth continues, and there isn't a massive kind of shift in in this financial restriction or rivalry with the US, and it becomes split out from EM, I don't think that will necessarily lead to less flows for either EMX China or for China. And if you look back at history, Japan became an incredibly dominant part of the Asia PAC universe, I think it got to about 70%, by 2001, when it was split out, but neither regions suffered less flows as a result, markets adapted and investors kind of worked with the new reality and got the exposure they wanted.

On North Asian markets, I suppose that's slightly separate. But I think it's interesting, you know, if these markets gathered more attention from global investors, they do, you know, the semiconductor and memory space, they do get attention, but these markets still have potential to develop in terms of their corporate culture. And I think that's potentially overlooked, because they're considered that the more developed part of EM, but there's, there's definitely a kicker from improving ESG. And that would come with more exposure to international investors and at a higher profile in markets.

Nick: Thanks. And then I suppose one of the kind of hot topics at the moment is commodities, given the inflation environment we're in and, and I suppose taking China out of the benchmark, you know, that really boosts the Middle East and LATAM. And I think Middle East is particularly interesting given today, in a broad emerging market benchmark, its of a size that it can potentially be ignored to a certain extent by some investors, whereas taking China out, it becomes quite a significant part of that universe. So, do you think an ex-China strategy is likely to be heavier in the commodity sector?

Alex: : As you said, I think the key thing you said there, is that potentially ignored? Well, I think that the last 18 months have been kind of a reminder of how important these regions are to the global economy. Right? You know, we've had 10 years of markets focused on digital businesses and technological growth and long dated investment cases. You know, the Middle East, Latin America, and commodity exporting countries, they've got what the world needs, right? So. So I think that as investment destinations, people are thinking about them more and considering perhaps more, holistically how important there'll be in the long term, even in a low, lower carbon world, you're going to need a lot of metals, you still need a huge amount of commodities, you need copper for electrification, lots of it, and you need platinum and precious metals to make hydrogen engines. So these parts of the global economy will continue to be important. And yeah, I mean, as, as an investor, certainly, you have to look at the Middle East very carefully, as an ex China investor, you have to consider things like the dollar peg, which can add risk to your portfolio, but also, you want to look at where domestic consumption is growing, as these companies increase their exports, that can create very powerful and attractive investment trends in the domestic economies. And at abrdn, our experience has been the best way to play a commodity cycle is to invest in the domestic consumption of companies that export commodities, because you know, the currency appreciates, economic activity grows, people consume more. And as they do that, businesses that can build up brands, banks, these businesses are higher margin, and the earnings are less cyclical. And that then is a more attractive way to invest potentially than directly in commodity companies over the long term where earnings can be more cyclical. Although, you know, some, some commodity companies - not all are born equal. So, there can be some attractive company t here.

Nick: Yeah, and I think that's certainly true. And that's one of the experiences of the last few months has been with Russia now removed from the benchmark and companies they're an investable, a lot of investors are having to look elsewhere for commodity exposure, either via some of the companies in Middle East or, or via companies, which are located in countries which will benefit from those increasing commodity prices. Thinking about correlations of emerging markets with China, as China moves to a domestically driven growth model. How do you think that's going to impact trade links between China and other emerging markets and that correlation?

Alex: Yeah, that's certainly a very powerful and interesting area, right? Because China does look set to increase its trade links with, with the rest of EMA and become an export destination over time. But, actually, a lot of that trend has been happening already. Because what we've seen is China sort of move up as Chinese people become more skilled and the economy becomes more sophisticated, Chinese companies have been able to move up the manufacturing value chain. And so the lower skilled parts of the manufacturing process have been moved out. And, just as you know, that wage arbitrage just as Western manufacturing went to China, in China, it's now being moved out to neighbouring countries in particular. So there are already trillions of dollars in imports from Vietnam, Malaysia, and the Philippines, and other EM countries, but I think particularly supply chains have moved, at least to neighbouring countries.

Now, the end consumer at the moment for these goods is, is generally in the West. So it's not necessarily that the manufacturing processes have been moved out of China, and Chinese consumers are now, you know, consuming all these goods, but the infrastructure has been created. And at the same time, as you mentioned, the Communist Party or the CCP, is deliberately steering the economy to be more domestically orientated, to grow services, to have more value, high value add jobs. And we see that with the technology companies, we know that there's a lot of high value add jobs in China, and this is growing steadily, actually, services are over 50% of GDP in China now, already. And that's increased incrementally over the last 20 years. So yes, over time, you know, that end consumer will shift more to China. And that will benefit the exporting companies, in the same way as exporting commodities is beneficial for your domestic economy, it's even more beneficial to make things and export those. And that in turn leads to, you know, it can lead to a fantastically powerful investment trend as economies move up the value chain and more people have higher value add jobs, and particularly as they consume more goods.

Nick: Okay, great. Well, it's been really interesting to get your perspective on that note, you know, it's we certainly are in the early days of this trend, given that there aren't that many strategies out there that have already started to exclude China from emerging markets. So it's good to feel quite early on that. So think I'd probably like to draw a podcast or close there and, and with that, thank you, Alex, for participating today. It's been great.

Alex: Thank you Nick.

Nick: And thank everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode and tune in.