The End of EM (part III)
Part 3: Point of No Return - the Future of EM without China
In parts I and II of this blog, we argued that President Xi’s election marked the end of the Deng era in China (a rising emerging market) and the arrival of the assertive Xi era (a fully developed country). And since the Deng policies drove the arrival of emerging markets as an asset class, the end of Deng brings the end of emerging markets (in terms of providing investors exposure to “fast growing, early stage economies for higher returns though with higher risk”) given China’s huge dominance in EM’s capital markets - China is classified as a EM country for technical reasons, not economic. In part III of this blog, we flush out the latter idea as well as look at the future of EM.
To start, why again does an assertive China bring the end of EM as a distinct asset class? As argued in part 2, China has effectively “emerged” given its staus as the 2nd largest global economy but also its specific “DM” achievements: advanced technology industry, superior military and even its own space station. These are not the typical characteristics of an early stage economy (which is what most investors seek when investing in EM). Index providers, though, classify China as EM given China’s closed capital account among other foreign investor restrictions (index providers main customers are US pension funds). Thus, similar to Taiwan and Korea, China remains EM status for technical reasons, not economic (note those three countries constitute almost 70% of the EM index). Thus, given the advanced nature of China’s economy (again same for Korea and Taiwan), global investors are essentially adding more “DM” exposure (mature, slower growth but less risk) to their portfolio. Thus the EM and DM country classifications and resulting distinct asset classes (with their own distinct portfolio characteristics) are becoming more and more meaningless, at least from a global portfolio construction perspective.
Yet for both corporates and global investors, China is unlikely to be seen, despite its advanced economic status, as a “DM” country inline with Europe or Japan. Exposure to the Chinese market comes with a different set of risks. The more President XI pursued an assertive agenda, the more the rest of the world reacted negatively (see Trump/Biden trade policies, Ant Financial cancelled IPO, spy balloons, etc). Thus investors and corporates likely feel, incrementally more so over time, less and less comfortable allocating capital to China. One could point to the rise of ESG or the war in Ukraine (China tactically supports Russia) but from 25i’s perspective, this “China is bad” view started the moment XI moved China from a passive, rising emerging market to an assertive, economic and geopolitical competitor with a political system starkly different from the West. The war in Ukraine or China’s Zero Covid policy simply crystalized a trend already in place.
Thus, every CEO and CIO are likely re-evaluating their Chinese exposure (think of how many corporate quarterly releases mention “supply chain issues” during the pandemic). For CEOs, they are understandably reluctant to make any changes to their Asian operations given China’s low cost positioning as any move likely leads to incrementally higher manufacturing costs and thus a lower operating margin. As for CIOs, they are reluctant to declare Chinese markets “off limits” given existing EM fund stated mandates but as well, likely shareholder capital losses given recent declines in Chinese markets. Thus the Chinese capital allocation case is challenged given DM-like levels of growth (mature economy) but with higher than DM-like levels of risk (geopolitical).
And if the Chinese investment case is challenged, then EM as an asset class is challenged. China (including Taiwan) is near 50% of the EM index but over 75% of trading liquidity thus dominating EM, thus as stated earlier, EM is China. An EM without China isnt an option either (though the ETF does exist) given the small resulting market cap size and trading liquidity, thus offering limited impact on a large global portfolio. “True” EM does have faster population growth vs DM countries but that core EM investment case only goes so far. India is usually lifted up as EM’s saviour but their economy nor their capital markets are as liquid to justify global funds (at least ones outside dedicated EM funds) allocating meaningful capital, especially if the Fed Funds rate is at 5%.
All these factors likely leads to more global selling of EM vs buying, thus creating potential for an “EM value trap” situation for a long time. Within EM, there will always be individual stock or country opportunities as in any market. The investment return of these opportunities may actually rise as the markets become less efficient (fewer investors involved). But EM, as a dedicated investment asset class is likely at its end given its no longer providing investors the exposure they seek. Investors should move to a world of stocks and countries each measured and valued on their own merits rather than using parameters coined in the 1980s but really launched by Deng Xiaoping’s reforms starting in 1978.
Thanks for reading.
