Identifier: Emerging Markets

India Gate, New Dehli, India.

Summary

  • EM equities were down through the month, with China the key drag as investors were disappointed by weaker than expected consumption figures.
  • Cyclical markets exposed to energy and commodities including the Gulf states and South Africa posted negative returns. Our view is that these parts of the market will remain vulnerable as the global economy deteriorates on the back of very weak money numbers.
  • Pro-democracy parties swept Thailand’s national elections, led by the progressive Move Forward Party which is set to form a governing coalition with Pheu Thai and four other smaller parties. However, a Senate dominated by figures appointed by the military government that seized power in a 2014 coup threatens to delay the appointment of the governing coalition and the appointment of Move Forward’s leader Pita Limjaroenrat as Prime Minister. Uncertainty will hang over Thai equities as the tussle between the coalition and the Senate plays out in the coming months.
  • Despite unorthodox economic policy sparking surging inflation and a collapsing economy, Turkish President Recep Tayyip Erdogan secured a third decade in power, winning a second round run-off against opposition coalition leader Kemal Kilicdaroglu.
  • Semiconductor names in Taiwan and Korea surged on the investor frenzy over AI technology sparked by Nvidia reporting Q1 sales and management guidance which were streets ahead of sell-side expectations.

India remains one of the best structural stories in EM

NS Co-CIO Ian Beattie returned from a research trip in India this month, and he was keen to emphasise that the story of India’s rapid rise is still on:

“My thesis that this still feels like China 30 years ago is intact. Now imagine that with strong institutions and democracy. Of course, we are dealing with a massive and diverse country – you have to embrace the mess, chaos, bureaucracy, the riots, shocking Gini coefficient and all that entails. BUT, it is improving in almost all of the important areas. And you make money on the delta, don’t you?

India as the fastest growing major economy has grabbed headlines but it is ongoing. Structural reform, societal change (slow), tax and social reform (incredible), it feels like a virtuous circle. United Payments Interface (UPI) is now a success on a global scale.

Sustained progress buttressed the popularity of Prime Minister Modi, liked by the poor as well as the shopkeepers. The poor and middle classes are getting wealthier and feel that there is less skimming from the top.

Infrastructure is improving, employment is up. Tax collection is up. It feels like things are improving for almost everyone.

I am seeing first-hand the increasing aspirations in younger generations. Though it will be a challenge for the government to stay ahead of this I imagine it opens up a completely new political landscape and many opposition parties will be unable to resort to traditional tactics.

Indian stocks are relatively less expensive than on my last visit, having traded lower and recovered to similar levels, whilst very strong GDP growth and good earnings have come through.

Foreign investors in Indian equities are back to a very small overweight, while locals fear a retreat by retail investors as positive momentum has faded.

Foreign investor positioning – modest overweight

Chart showing India weight in EM funds as compared to benchmark weight.

Source: Jefferies, 2023.

However, this misses the structural story at play which is becoming increasingly important – that is the rising importance of domestic flows from local mutual funds seeing inflows from Systematic Investment Plans (SIPs).

Structural change in EM can be a key return driver

Chart showing SIP contribution compared to number of SIP accounts (m), RHS from January 2018 to April 2023.

Source: Jefferies, 2023.

Flows from a young and growing cohort into domestic mutual funds are boosting local liquidity, with long time horizons suited to equities exposure and more incentivised than foreign investors to push on Indian corporates to improve governance.

Be careful of relying too much on your mean reversion tables when structural change like this is underway. Prices are no longer set in London or New York, but rather in Delhi or Mumbai.”

India’s embrace of digital payments infrastructure is supercharging its development

India is a country of 1.4 billion people, 22 languages, 1 billion mobile connections and 800 million internet users. Yet only 6% are income taxpayers and only 6% transact digitally for commerce.

Leveraging technology and widespread connectivity is seen by policymakers as a massive development opportunity to draw more people into the formal economy while supporting innovation and relieving economic bottlenecks in India.

Enabling access to banking is an early example of how digital technology is being utilised – banking penetration went from 20% of the population in 2008 to 100% by 2017/18. During the pandemic, banking access – linked up to the Aadhaar digital identification program and the United Payments Interface (UPI) – was pivotal in enabling the swift and targeted transfer of around $4.5 billion worth of benefits to 160 million beneficiaries.

India has emerged as a leader in the development of Digital Public Infrastructure (DPI), which is pervasive and inclusive with 1.36 billion unique digital IDs, facilitating tens of billions of payments each year, and covering 10 million GST-registered companies.

At the heart of this is UPI, a real-time payments system established in 2016 which has quickly become the world’s largest real-time digital payments market. In 2020, 25.5 billion transactions were registered on UPI. The technology allows users across India to use their smartphones to quickly set up and transact using cardless accounts accessed using personalised QR codes, and utilise services including overdrafts, autopayments and voice-based payments. The system is even being expanded internationally, enabling free and instant cross-border transactions (versus pricey transactions via SWIFT) in a number of different currencies to and from India, which is the world’s largest remittances market – worth over US$100 billion in 2022 (World Bank). 

This has been a game-changer for India. Besides our oft-quoted reforms (bankruptcy law, demonetisation, clean water and electricity roll out, infrastructure spending, public toilets in rural areas, etc.), UPI has proven incredibly successful and has been crucial in ensuring welfare payments get to the right people, reducing waste and corruption, increasing tax revenues and giving more people bank accounts and phones.

What does this all mean for investors in emerging markets? While positive, initiatives like UPI, bankruptcy reform or sanitation may seem relatively trivial in isolation. However, it is the compounding effect of these incremental steps over a sustained period that can create a virtuous circle that unlocks the next upward shift on the development ladder. For a country the size of India, that progress will see several hundred million Indians join the formal economy and accumulate wealth, which can in turn present a host of opportunities for investors with the framework to harness these structural tailwinds.

Global growth optimists expect continued solid services sector expansion to offset manufacturing weakness. PMI results for May appear, on first inspection, to support this view: services activity and new business indices rose further to 18- and 22-month highs respectively even as manufacturing new orders remained stalled below 50 – see chart 1. 

Chart 1

Chart 1: Global PMI New Orders / Business. Chart compares manufacturing new order vs. services new business from 2015 to 2023. Source: Refinitiv Datastream.

There are, however, several reasons for discounting the strong headline services readings. 

First, backlogs of services work fell sharply to a four-month low despite stronger new business – chart 2. This suggests that current output is running ahead of incoming demand, in turn implying a future adjustment lower unless demand picks up further. 

Chart 2

Chart 2: Global PMI Backlogs of Work. This chart compares manufacturing vs. Services from 2015 to 2023. Source: Refinitiv Datastream.

Manufacturing backlogs also fell sharply last month, breaking below their November 2022 low. 

Secondly, the sectoral breakdown of the activity and new business indices shows that May rises were driven by a surge in financial services – chart 3. Consumer services indices eased on the month. Financial services strength is difficult to understand given monetary stagnation, slowing bank lending and flat trading volumes, so may prove short-lived. 

Chart 3

Chart 3: Global Services PMI New Business. This chart compares consumer, financial, and business from 2015 to 2023. Source: Refinitiv Datastream.

Thirdly, the high May readings of the global activity and new business indices reflect strong contributions from the US and Chinese components but national services surveys are significantly weaker. 

The US ISM services activity index fell to a three-year low in May even as the S&P Global equivalent series reached a 13-month high – chart 4. 

Chart 4

Chart 4: US Services PMI Business Activity. This chart compares S&P Global vs ISM from 2015 to 2023. Source: Refinitiv Datastream.

The Chinese NBS non-manufacturing new orders index moved below 50 in April and fell further in May, in puzzling contrast to the S&P Global / Caixin services new business index, which reached its second-highest level since November 2020. 

The global manufacturing new orders and services new business indices have been strongly correlated historically but statistical tests indicate a tendency for manufacturing to lead services rather than vice versa*. With global monetary trends continuing to give a negative economic signal, the current unusually wide gap is more likely to be closed by services weakness than a manufacturing revival. 

*In regressions using monthly data with three lags, lagged manufacturing new orders terms are significant in the regression for services new business, but lagged services new business terms are insignificant in the regression for manufacturing new orders.

Road intersection illuminated by neon lights in downtown Shanghai at night.

With the economic recovery slowing, one of the few central banks reducing rates due to deflation fears, increasing trade tensions and geopolitical escalation, risk-averse foreign investors are reducing their weighting of China’s financial markets. This decline in investment is driving down both stock prices and the value of the yuan.

The real estate sector, which combined with related industries accounts for 20% to 30% of China’s GDP, has not rebounded as expected. China’s new home sales by area fell 11.8% on the year in April, following a drop of 3.5% in March.

I recently spent close to a month in China, visiting relatives and friends for the May Day holiday that runs from April 29 to May 3. I also had the opportunity to meet many entrepreneurs, government officials, professionals and students as well as many of our holdings and companies we are interested in.

I spent a few weeks in Jiangsu province, a province about the size of Portugal or Kentucky that borders Shanghai. It is a province of 85 million people that has the second-highest GDP per capita (US$21,647 nominal), again higher than Portugal or Greece. If it were a country, it would be the 10th-largest economy in the world, just behind Canada and ahead of Brazil. As a US state, it would be the fifth-largest by nominal GDP, just behind Florida.

I also spent a week in Sichuan and its capital Chengdu, a modern metropolis of 26 million people, the fourth-largest city in China. The country’s so-called Western capital, Chengdu’s history dates back over 5,000 years. Nowadays, it is recognized by UNESCO as a city of gastronomy and is most often associated with the giant panda that makes the region its home. Although 1,700 km away from Shanghai, it is considered a beta+ (global second-tier) city, together with places like Washington DC, Miami, Houston, Berlin and Barcelona. More than 300 Fortune 500 companies have operations in Chengdu.

I spent my last week in Shanghai which needs no introduction, a global metropolis of 34 million people.

I will share my observations in no order of importance.

Geopolitics

During my stay, I did not witness or hear much about trade issues and other tensions that North American news outlets tend to cover. There is almost no coverage of the war in Ukraine. Most ordinary citizens have neither a pro-Russia nor pro-Ukraine view. Instead, news coverage focuses on the positives. Examples include projects or investments, cooperation deals and cultural exchanges between China and the rest of the world, from Morocco to Malaysia.

I did not feel any animosity towards me, a Caucasian man from North America. I found going through customs and travelling across China easier even than before COVID.

I also noticed much fewer foreigners. I was told that the Germans and Japanese still have an important presence, but Americans are seemingly gone. Also noticeable is the number of African businesspeople and students.

COVID and its aftermath

COVID has had a profound effect on the Chinese population. From mid-2020 to mid-2022, the country was isolated. There were almost no cases and life continued almost normally while much of the rest of the world was under some restrictions. Then the world reopened and China implemented the harshness measures of confinement and quarantine. In Shanghai, people were restricted from leaving their apartments for over two months. Hospital doctors and nurses stayed at work knowing that if they left, they could not return. People have been traumatized. More on this later.

After reopening last Fall, life today is largely back to normal. Except for an antigen test required for arrivers to China, there are almost no COVID measures. Maybe 10% of people wear masks, but they are not compulsory anywhere, even in hospitals. For foreigners, the country accepts valid visas that were issued before COVID and has resumed issuing new 10-year travel visas.

Most Chinese people have caught COVID, often more than once. 

The strength of the economy

China’s economy is the world’s largest by GDP based on purchasing power and second by nominal GDP. In August 2021, President Xi Jinping first introduced the concept of common prosperity. The goal is to reduce inequalities and make regional development more balanced and people centered.

Chart 1: chart showing largest economies in the world by PPP GOP in 2023, according to International Monetary Fund estimates.

Barring a more significant decoupling from the US and some European economies, the Chinese economy is on a path to expand modestly over the next few years – the government’s goal is 4% to 5%. Is it achievable? Even if growth did not reach these levels, we believe the country still presents many opportunities. Let’s review important sectors of its economy.

The real estate sector

Foreign investors have called the Chinese real estate market a bubble for at least 20 years. It probably was to a certain extent, but it had solid underpinnings including China’s rapid urbanization. For example, Chengdu more than doubled its population between 2000 and 2020.

A foreigner visiting China for the first time might think that construction is booming. For myself, a regular traveller to China since 2000, construction has never seemed so slow. The number of new projects is the lowest I have ever seen. The number of stalled projects in every city is noticeable.

What does that mean? A recession in China and a collapse that resembles the Great Financial Crisis of 2008?

Given the importance of the real estate sector in China, a slowdown will have a large impact on its economy. But also on many commodity-producing countries. 

A full-blown financial crisis? I do not think so! Why? 

In China, more than 90% of households own their home, probably the largest percentage in the world.  Housing is 59% of household total assets. However, just 18% of households have a mortgage. That compares with more than 50% in the US and Canada. Most mortgages are variable rate and rates have declined recently. A decline in property prices would not bankrupt people but a negative wealth effect would be felt.

The same can’t be said for property developers. We have already seen the world’s largest, China Evergrande Group, default on some of its debt obligations and struggle to restructure its more than US$300 billion debt load.

Who will lose? Bond holders, including US-based. Now, the default rate of US-dollar real estate bonds in China has risen to over 50% for a loss of over US$40 billion so far.

The big Chinese banks, all government controlled, will absorb much of the losses. It may explain why the world’s largest bank, Industrial and Commercial Bank of China (ICBC), a bank twice the size of JP Morgan Chase and four times the size of Royal Bank of Canada by assets is trading at 4.8x earnings (P/E) and pays a dividend of 6.24%. So, we see the risk of a full-blown financial crisis as small to moderate.

Why do we think real estate will probably never recover to its prior levels? Demographics is a main reason. China’s working population stopped growing about 10 years ago. Its actual population declined for the first time in 2022. However, its urbanization rate is still a positive driver. Now at 65%, it is expected to reach 80% by 2035, which means an additional 200 million people moving to urban areas in the next 10 to 15 years. 

I have found the psychology around owning a house very different from my previous trips to China. Following the quote by Xi Jinping that houses are for living and not speculating, Chinese people are not so certain anymore that house prices can only rise. With the establishment of the property register and the expected real estate tax system being implemented soon, it will no longer cost anything to carry an empty house. Ownership of multiple empty apartments, which by some estimates exceeds 100 million, indicates there are more sellers than buyers. There are more ways for Chinese people to accumulate wealth, including an expanded stock market and other options for international investing. Finally, I have observed that the younger generation seems less interested in home buying, probably expecting to inherit one of many from their families as most are only children with two parents and four grandparents who are likely homeowners.

Reasons for China’s youth unemployment problem? 

Not unlike many countries, there is a mismatch between the needs of the job market and the expectations of graduates. Joblessness among young people aged 16 to 24 rose to a record 20.4% in April, far above the pre-pandemic rate high of 13% through much of 2019.

The rise was more surprising given that China’s urban unemployment overall fell to 5.2% as of April, compared with 6.1% a year earlier. The government is trying to encourage state-owned enterprises to hire new graduates. It is also running a campaign to promote job opportunities in more manual and technical professions. 

Talent Boom - number of new university graduates in China. Note: 2022 and 2023 figures are estimates.
Sources: China’s National Bureau of Statistics, China’s Ministry of Education.

Will the “lying flat” generation rise? It certainly represents a huge pool of talent and given the relatively young retirement age (55 for women, 60 for men) and the lower birth rate, we believe this issue should get resolved relatively soon.

Where will growth come from?

So, what sectors may take the baton and contribute to future growth?

Like most mature economies, China is experiencing an enormous need for services sectors, from hospitality and tourism to healthcare.

One sector that continues to grow and benefits from investments is infrastructure.

The infrastructure sector

In its latest five-year plan, China aims to expand its expressways to 130,000 kms by 2027, up 11% from the end of 2021. This will add to what is already the biggest such network in the world. By comparison, the US had about 98,000 kms of expressways as of 2020 based on data from the Federal Highway Administration.

China’s high-speed rail network, run by state-owned China State Railway Group, spanned 42,000 kms at the end of 2022 – the longest in the world, and 13 times the size of Japan’s shinkansen bullet train network. The five-year plan will expand it by another 26% to 53,000 km in 2027. And North America still has zero kilometres.

More airports will be built, bringing the total to around 280 from 254 as of 2022.

Nationwide fixed-asset investment in transportation reached a record ¥3.8 trillion (US$537 billion) in 2022 and is set to remain about the same each year for the next five-year plan.

Again, as a comparison, the bipartisan infrastructure bill passed by President Biden at the end of 2021 authorizes up to $108 billion to support transportation projects between 2022 and 2026.

Tourism – another growing sector

One sector that China counts on to stimulate its economy and create millions of jobs particularly in remote regions is tourism. China’s domestic tourism sector is the largest in the world and China was the third most visited country by foreigners in 2019. The World Travel & Tourism Council (WTCC) expects the tourism sector to create over 30 million jobs in the next decade for a total of over 107 million people employed in tourism. Travel and tourism is expected to grow at an average of 9.7% over the next 10 years, twice the expected growth of the country overall, representing 14% of the economy.

To give you a sense of numbers, during the May Day holiday period, the first holiday after three years of strict COVID controls, more than 270 million domestic trips were made by car, rail, airplane and waterways, up 163% from last year, according to the Ministry of Transport. Railway and airplane trips exceeded 2019 pre-pandemic levels by 22.1% and 4.2% respectively, according to the ministry.

We believe that the tourism sector, which was growing faster than GDP before COVID, will continue its growth trajectory in China and elsewhere. “YOLO” seems to be one of the lasting effects of COVID.

Innovation as a growth engine

Of the 8.3 million students who graduated in China in 2021, more than half earned science, technology, engineering or mathematics (STEM) degrees. That compares to about 450,000 degrees in similar disciplines in the US.

According to the World Intellectual Property Organization (WIPO), China accounted for 46.6% of all patents issued in 2021, or 1.6 million patents, up 6% from the year before. The US was second at 17.4% or 591,000, down 1% from 2020. It was followed by Japan at 8.5% and the Republic of Korea at 7%. India was far behind with 61,000 patents.

This innovation can be seen everywhere in China. In consumer electronics for example, Apple has been stuck at around 20% market share for the last few years. In Shanghai, I saw a lot more people in the Huawei store than in the Apple store across the street. 

Why are Chinese brands across industries such as consumer electronics, appliances and apparel gaining market share in China? Unlike global brands, they are often specifically made for Chinese customers, understanding their preferences.

A sector where innovation and the rise of Chinese brands is particularly visible is electric vehicles (EVs).

One of the first things I noticed when I landed at most airports or ordered Didi (the equivalent of Uber) is that most cars in China are electric. Electric cars have a green license plate whereas gasoline-powered cars have blue plates.

In 2009, China became the world’s largest car market. In 2023, it will become the second-largest car exporter, behind Japan and ahead of the US and South Korea. In 2022, 27 million vehicles were sold in China compared to 14 million in the US. In China, 7 million of the cars sold were EVs. That’s 25% of the market. In the US, 750,000 were sold, or 5.6% of the market.

Much like the US in the 1920s, there are over 100 EV car manufacturers in China. In the US, by the 60s, the big 3 dominated. We can expect the Chinese market to have four or five dominant brands in 10 years.

China top 5 EV maker sales share in 2022

BYD (Build Your Dream), the company Warren Buffett invested in, had 29.7% market share in 2022, up from 18% in 2021. Six of the top-10 EV models sold in China in 2022 were BYD. And the company is at the top of the list when I asked people what EV car they would buy.

GM, which includes the joint venture with SAIC, had 8.9% market share. I saw many Buick electric models in China that are not available elsewhere.

Tesla is third at 8.8% market share, down from around 14% in 2021. Interestingly, when discussing cars, most people still associate luxury and aspirational brands as German, with names like Audi, Mercedes and Porsche. Tesla is not viewed as a luxury brand in China, but just another EV car brand. And with questionable quality and inferior software, a very different impression from the typical North American view. Its market share continues to drop in 2023, despite drastic price cuts.

In fourth place and growing fast is Geely, which also owns Volvo and Polestar, with 5.2% market share.

And in fifth place, Changan with 4.5%, market share and also growing.

Looking at January 2023, here are the top-15 models sold that month.

Chart showing Top selling electric vehicles in China (as of January 2023).
Source: Cleantechnica.

When looking at the lead Chinese EV makers, could the rest of the world catch up? The answer is probably not. Looking below at the battery supply chain explains that even with battery gigafactories built by most western automakers, the dominance of Chinese companies is structural.

Diagram showing the process of cobalt mining & refining, cathodes, adodes and battery cells for electric cars.
Source: Cleantechnica.

This note may seem optimistic and I am. I also visited China’s largest publicly listed funeral services company, Fu Shou Yuan (1448 HK). We own it in our emerging markets fund. Last year, the company assisted over 74,000 families to honour their deceased family members.

I also visited Raffles Medical Shanghai Hospital (RFMD SP), a brand new, 400-bed tertiary hospital in the heart of the fastest growing new area of Shanghai. We have owned Raffles Medical, a Singapore-based healthcare company building a network of clinics across Asia and China, in our global and EAFE fund for the last seven years and profiled it before in these weekly comments.

There are a lot of opportunities in China, despite the rhetoric that it is un-investible.

In the last few weeks, the CEOs of JP Morgan, Starbucks, Volkswagen, Tesla and many others have gone to China and reiterated the importance of globalization and cooperation, not decoupling from China.

If, however, the situation deteriorates further, our role will be to navigate these risks and identify opportunities for our clients.

If you would like to discuss more, do not hesitate to contact us at Global Alpha.

Monetary trends continue to give a negative message for global economic prospects, suggesting that European / US weakness will outweigh resilience in major EM economies. 

G7 plus E7 six-month real narrow money momentum fell again in April, extending a move down from a local peak in December and suggesting a decline in economic momentum through late 2023 – see chart 1. 

Chart 1

Chart 1 showing Global Manufacturing PMI New Orders & G7 + E7 Real Narrow / Broad Money (% 6m)

A revival in real narrow money momentum in H2 2022 was reflected in a recovery in global manufacturing PMI new orders between December and March. The recovery stalled in April / May and the forecast here remains for a relapse and possible retest of the December 2022 low during H2 2023. 

Narrow money has outperformed broad money as a leading indicator historically, in terms of reliability in signalling turning points in economic momentum. Narrow money usually weakens relative to broad money when interest rates rise as depositors are incentivised to shift funds to less liquid accounts. This is an important feature of the transmission mechanism and one of the reasons narrow money outperforms as a forecasting indicator. 

An argument, however, has been made that the unusual speed of the rise in interest rates over the past year, coupled with worries about deposit safety following recent bank failures and an associated switch into money market funds, may have exaggerated narrow money weakness relative to “true” economic prospects. This would suggest giving greater weight to broad money trends at present. 

As chart 1 shows, global six-month real broad money momentum recovered more strongly during H2 2002 and has stalled rather than fallen back since December. Still, the message for economic prospects is weak, suggesting no growth revival before 2024. 

A marginal decline in global manufacturing PMI new orders in May reflected a notable weakening of the DM component offset by stronger EM results. EM resilience is consistent with recent stronger E7 real money momentum (broad as well as narrow) – chart 2. 

Chart 2

Chart 2 showing G7 + E7 Real Narrow Money (% 6m)

Charts 3 and 4 show six-month real narrow money momentum and manufacturing PMIs in selected major economies. Russia, China and India top the real money momentum ranking with weakness focused on Europe – particularly Switzerland and Sweden. The latest PMI results mirror the real money ranking (rank correlation coefficient = 0.85), with recessionary readings in the Eurozone, Switzerland and Sweden contrasting with Indian / Russian strength. 

Chart 3

Chart 3 showing Real Narrow Money (% 6m)

Chart 4

Chart 4 showing Manufacturing Purchasing Managers’ Indices
Cityscape of Guiyang at night, Jiaxiu Pavilion on the Nanming River. Located in Guiyang City, Guizhou Province, China.

Summary

  • EM equities were weak through April as the global economic backdrop continues to deteriorate.
  • Negative global excess money continues to feed a slowdown globally, along with falling inflation.
  • The global liquidity backdrop should become less negative as yields peak and industrial output begins to bottom. This should increasingly favour quality growth, tech and defensive (excluding energy) names.
  • China’s economy continues to buck the trend, enjoying a modest reopening bounce. However, this recovery may not be enough to offset weakness elsewhere in the world.
  • Chinese equities were down through the month and are flat for the year. Leading names in China this year have typically been SOEs boosted by government reform initiatives, banks and some energy names. Our favoured quality growth names have underperformed despite benefiting from the reopening and continue to trade at compelling valuations.
  • General elections in Thailand approach, with pro-democratic opposition parties poised to oust the military-linked conservative coalition.
  • Turkey is also set to hold presidential and parliamentary elections in May. President Erdogan is likely to face a stiff test from opposition coalition leader Kemal Kilicdaroglu, who has pledged to restore economic orthodoxy to address a deepening economic crisis. Political risk is high, with a return to Erdogan likely to court a currency crisis and add further pressure to the country’s strained banking system. 

Mixed signals from China’s reopening

The modest recovery in consumer spending and industrial activity this year has fallen short of investor expectations, with Chinese equities flat for the year. We agree recovery signals have been mixed, which aligns with our previous commentary flagging that authorities in China have been content with a gradual pick up as opposed to the V-shape boom that we saw in the West. Beijing is clearly wary of pouring excessive fiscal and monetary stimulus on the recovery lest it spark an outbreak of inflation.

The government has done little other than offer rhetorical support for business. The Politburo met in late April, with President Xi noting weak economic momentum and subdued demand. Policymakers kept their options open with respect to fiscal and monetary support, pledging a “forceful and effective” approach while reiterating that curbing speculation in property and taming local government debt remained high priorities. Following on from the two sessions last month where new Premier Li Qiang touted the party’s support of business, the Politburo provided another forum to pledge to restore business confidence through the “[elimination of] any legal, regulatory or hidden barriers preventing the fair competition and common development of enterprises of all ownership forms.” 

While the policy restraint may frustrate some China bulls, data from China’s Labour Day holiday at the end of April into early May suggests that Chinese consumers are back travelling and dining with a vengeance.

  • China Daily reported that on Friday, April 28, the day before the holiday started, train tickets departing Shanghai Hongqiao station to destinations nationwide were sold out.
  • Over the first three days of the holiday, approximately 160 million people travelled by air, road or waterway, an increase of over 162% versus the same period in 2022 (China Daily).
  • More than 240 million people were estimated to have travelled over the full five-day break, double the pre-COVID level in 2019 (Jefferies).
  • Domestic flights during the period are over 4x above 2022 levels (Jefferies).
  • Sales growth over the holiday period across catering, apparel, jewellery and tobacco were up 21.4%, 20.9%, 17.4% and 16.8%, respectively, versus 2022 (Jefferies).

NS Partners analyst Michael Zhang is currently travelling in China and sent us some photos of what he calls “revenge travel” over the holiday break.

The trend is positive but fragile – consumers are getting out but overall spending is still relatively weak – and monetary data remains supportive with additional scope for further easing should deflation risk emerge and external headwinds build.

Chile’s president looks to cash in on battery boom through lithium nationalisation

Chile’s government announced that it would seek to capitalise on the global battery boom by nationalising its lithium industry. The stocks of the two main Chilean lithium players, SQM and Albemarle, were hit by the news, with some investors fearing a repeat of the nationalisation of Chilean copper mines in 1971 by the socialist Allende government, where assets were seized from foreign miners without negotiation. The move was a disaster, as foreign engineers and investors left Chile, and just as a global recession in 1973 was about to precipitate a collapse in copper prices. Allende was ultimately ousted in a CIA-backed coup, and replaced by right-wing despot Augusto Pinochet.

This proposal illustrates the importance of factoring political risk and institutional quality into our process. While Boric risks kicking an own goal here, our analysis makes us relatively sanguine about prospects for the Chilean miners SQM and Albemarle, as the president must ultimately pass the law through a centre-right leaning Congress. The legislature is a key check on the ambitions of the president, illustrated by the rejection of a tax reform proposal in March and failure to implement a progressive constitutional reform in a plebiscite last year, with opposition led by right-wing congressional figures.

If the nationalisation plans were to pass through Congress, the government has committed to honouring existing contracts (SQM’s runs to 2030 and Albemarle’s to 2043), while encouraging the miners to negotiate state participation before expiry. It is likely that the miners will engage in and drag out negotiations on state participation as much as possible, while they generate supernormal profits at these elevated lithium prices.

While the market reaction on the news was an overshoot, we were not tempted to add to our exposure. Lithium price strength will ultimately incentivise significant new supply to come online across South America and Australia in the coming years. Additionally, we are happy to maintain an underweight to commodities broadly, based on our outlook that weak global liquidity will feed an economic hard landing that drags on commodities.

PETRONAS Twin Towers in Kuala Lumpur, Malaysia.

The strategy saw strong contributions from holdings in ASEAN (Indonesia, Malaysia, and the Philippines) and the Middle East in the quarter. However, this was more than offset by losses in the Africa portfolio. As we have written in previous letters, we have been actively reducing the strategy’s exposure to Africa (specifically Egypt and Kenya) and increasing it in ASEAN and the Middle East (Saudi Arabia and the United Arab Emirates). African economies are undergoing severe macroeconomic headwinds that have overwhelmed equity returns and exerted pressure on earnings. Conversely, ASEAN and Middle Eastern economies have been performing reasonably well, allowing us to harvest healthy USD equity returns through earnings growth and multiples expansion.

Continuing with the above theme, we decided to fully tender out the strategy’s shares in East African Breweries Ltd. (EABL) to Diageo PLC at a price of KES 192/share (compared to the KES 170/share price as of the date of this letter). While Diageo paid a premium of 35% versus the one-year average (at the time of the “intention to acquire” announcement in October 2022), the deal multiples were highly favourable to Diageo at ~14x 2023 earnings, a substantial discount to emerging and frontier market brewers. We tendered out at these low multiples because of two factors: first, there are limited incremental buyers for EABL given the macroeconomic environment and stock market illiquidity in Kenya; second, the Diageo bid presented a relatively lucrative way for us to reduce exposure to Africa, in line with our strategy. Following the deal, EABL will remain listed on the Nairobi Stock Exchange with Diageo’s ownership now up to 65%, from just over 50% pre-tender. We will continue to monitor EABL and potentially re-enter the stock once the economic environment in Kenya settles.

The strategy was very active during the quarter in both ASEAN and the Middle East. In ASEAN, we invested in CTOS, Malaysia’s leading private credit reporting agency, which holds over 70% of the country’s credit reporting market. Due to the high barriers to entry in this industry, market leaders like CTOS are likely to sustain their position as they continue to compound their data sets and create new use cases for their customers. Malaysia is a particularly underpenetrated market for credit reporting, as financial institutions still rely heavily on their internal data and the public credit bureau in their loan underwriting process. Malaysia is interesting because financial inclusion is high at around 95%, yet 65% of the population still does not have a regulated credit account. As financial sophistication grows and credit compliance requirements tighten, demand for CTOS’s services should increase significantly. CTOS’ scale and technology underpins operating income margins of ~40% while compounding operating income growth at ~20%. We have followed CTOS since it listed on the Bursa Malaysia in July 2021, but had reservations on its valuation and the previous management team, who we thought were brought on just to list the company rather than the focus on generating long-term value. When the previous CEO left the company, we went to Kuala Lumpur to meet with the new CEO, Erik Hamburger, a former executive at Experian, who articulated a growth strategy around product development, digital investments, and sales strategy that we thought, if well executed, would unlock tremendous value for shareholders. With a positive view on the company and management, it was a case of waiting for a valuation opportunity to open, which finally happened in this quarter.

The strategy also invested in Al Ansari Financial Services (AFS), a UAE-based remittance and currency exchange house. AFS is a leader in the second-largest market remittance market globally (after the U.S.). The company generates revenues from facilitating the remittance of money flow from the UAE to countries in Asia (example: Philippines), Sub-continent (India and Pakistan), and the Middle East and North Africa (Jordan and Egypt). AFS focuses primarily on small ticket remittance, a market that banks are strategically not interested in, and that fintechs have found difficult to penetrate. For context, the company reports that 67% of the remittances it facilitates are less than $400 per transaction. AFS has a robust offline network in 226 carefully selected locations across the UAE, which captures monthly remittance flows from blue-collar and underbanked white-collar workers. This offline network is supported by a strong online presence, where it has a top ranked app that processes 41% of personal digital outward remittances among exchange houses. AFS’ management have executed well, deepening the company’s competitive advantage, and translating that to operating margins of ~50%, on healthy mid-teens top line growth.  

Despite the softer performance during the first quarter, we remain constructive on the strategy’s outlook. We believe the current environment is ripe for stock pickers, with valuations as attractive as they’ve been since we launched the strategy in 2018. Moreover, the economic environment is expected to deepen the competitive edge of portfolio companies in their respective markets.

As we have done in previous letters, we sign off by reminding our investors that our objective is to deliver differentiated returns that are attributed to investing skill (alpha) rather than market directionality (beta). We believe there are abundant alpha opportunities in frontier and emerging markets, which we choose to express through a concentrated but geographically diverse portfolio of companies with idiosyncratic earnings drivers and share-price catalysts. Naturally, this should result in significant deviations from global and emerging market indices in certain periods, but hopefully provide a superior risk-adjusted return profile to investors in the long term.

Vergent Asset Management LLP

Night View of Dubai Architecture Complex.

Gulf equity markets underperformed their emerging market peers (as measured by the MSCI Emerging Markets Index) for the second consecutive quarter. This weaker market performance can be attributed to some of the same factors we highlighted in the Q4 2022 Manager Letter namely, higher interest rates and lower oil prices. These factors present a headwind to earnings growth for the banking, energy, and materials sectors, which together constitute 69% of the S&P Pan Arab Composite Index. Banks have been a particularly sore area for the market, with profitability ratios starting to crack under the pressure of higher rates and concerns about capital allocation and corporate governance at two large banks in Saudi Arabia and the UAE. The news of indirect exposure to Adani Group companies and a potential acquisition of Standard Charter Group at First Abu Dhabi Bank, combined with the write-down of the unfortunate Credit Suisse investment at Saudi National Bank, provided further reasons for the sector’s underperformance this quarter.

However, if we look beyond the Index’s major sector constituents, the overall market sentiment is clearly bullish. For example, in Saudi Arabia, out of the 229 stocks comprising the Tadawul All-Share Index, 174 stocks generated positive returns in the quarter. In the UAE, IPO activity has been robust and share prices of recent entrants such as Salik Co., Emirates Central Cooling Systems Corp. and ADNOC Gas are well above their offer prices. While the performance divergence between the broader market and the Index is easy to attribute, the magnitude of the divergence (in favour of the former) is noteworthy. It is evident that investors are increasingly reducing their exposure to banks and materials while increasing their exposure to other sectors, such as consumer, healthcare, and technology, where liquidity is relatively less accommodative and therefore prone to larger stock price moves.    

The context is important in partially explaining the strategy’s outperformance in the quarter. The aforementioned dynamics led to meaningful valuation multiples expansion for the strategy’s key portfolio companies. However, we also anticipate a robust earnings growth outlook for many of our core portfolio companies. For example, National Co. for Learning and Education (NCLE), a prominent Saudi K-12 school operator, reported year-on-year revenue and net income growth of 48% and 50%, respectively, in its last quarterly reporting period. Our team spent a day touring various NCLE-operated schools with the CEO in Riyadh and we were thoroughly impressed with the quality of the staff, facilities, and unique culture preserved by management dating back to NCLE’s roots as a family-run enterprise. 

The strategy’s returns also benefited from a sizeable position we have been building in Saudi Telecom Co. (STC), Saudi Arabia’s leading telecommunications provider. Our thesis on STC has been largely driven by valuation, which has been developing since the Public Investment Fund (PIF) offloaded a 6% stake in STC in December 2021. This event stoked fears of future sell-downs in the stock from the PIF, which currently owns 64% of the company. While we cannot be sure that the PIF will not sell more shares of STC in the future, we found that valuations were becoming increasingly attractive for such a dominant business, with free cash flow yields exceeding 10% for 2023. Our thesis received a strong boost from STC collecting nearly $4bn of outstanding receivables from government clients in the fourth quarter of 2022, which represented 8% of its market capitalisation at the time. We met with STC’s management at an investment conference in Dubai and were encouraged by their efforts to improve disclosure and transparency for the investor community.  

As mentioned earlier in the letter, banks have lagged Gulf equity markets. This is a phenomenon that also played out in the strategy, with five of the eight negative return stocks in the quarter coming from the sector. While we have a significant underweight in banks, the strategy’s absolute returns experienced a drag from Saudi and Qatari banks, where pressures on profitability are building up as cost of funds increases at a higher rate than yields on assets.   

The strategy also experienced underperformance in its North African portfolio, and particularly in Egypt, where severe macroeconomic headwinds have overwhelmed USD equity returns. We have been reducing the strategy’s exposure to Egypt over the last year but opted to keep a level of investment in our highest conviction portfolio companies there. 

Looking ahead, we continue to see favourable opportunities for the strategy. The macroeconomic backdrop remains supportive, with healthy FX reserves and balance of payments positions across most of the Gulf. While still early days, the Saudi-Iranian reproachment is a key event that warrants our attention, as any progress there can lead to a lower geopolitical risk premium on regional assets. OPEC+ is committed to maintaining high oil prices to support government spending plans, which could benefit equity markets. We also note that positioning from global emerging market funds remains light and governments in the region are intent on growing their share in the emerging market capitalisation, which we believe will end up manifesting itself in a quasi-short squeeze on those funds.  

The environment is highly dynamic in the region, and as active managers, we are willing to make bold decisions to ensure that the strategy continues to provide investors with attractive opportunities in the MENA region.

Vergent Asset Management LLP

Bamboo forest in Kyoto, Japan.

At Global Alpha we are macro aware but don’t make macro calls. Being macro aware helps us evaluate investment opportunities through the lens of a country’s economic indicators, politics and regulatory landscape. It can also be an important risk management tool, especially in emerging markets.

Macro awareness also comes from understanding a country’s policy choices on its path to success or failure. An exceptionally interesting book called “How Asia Works” by Joe Studwell, provides unique insights into why North Asian countries (Japan, Korea, Taiwan and China) have managed to achieve sustained economic growth while South Asian countries (Thailand, Malaysia, Indonesia and the Philippines) seem to have stalled on their way to economic success. The book answers several questions including:

  • Why successful industrial brands like Haier, TSMC and Hyundai emerged from North Asia and not South Asia.
  • How the Philippines went from being twice as rich as Korea to 11 times poorer in half a century.
  • Lessons that other emerging markets can learn from ones that have experienced growth and success.

The last point is particularly useful to our investment process. If there was a common thread (or formula for success) across North Asian economies, it would be the following.

Step 1 – Small gardens beat large ranches (Land reforms)

This is the crucial initial step, yet also the stage at which most countries falter. Achieving sustained economic growth of 7% to 10% over a significant period requires making tough political decisions, such as redistributing land in a peaceful manner. Following WWII, many North Asian economies were poor and had a surplus of labour in rural areas. However, land ownership was concentrated in the hands of a few wealthy and connected landlords.

The key to unlocking growth in this situation was to peacefully redistribute land from these connected landlords to small rural farmers and peasants. This approach is counterintuitive to what neo-classical economists might recommend, which is to establish massive, mechanized farms to maximize profit per acre. Instead, an intensive gardening approach on a small plot can deliver maximum crop yield.

The effect of this type of reform is that it fully employs the abundant labour available in rural areas. Increased agricultural output leads to sharp increases in purchasing power, waves of consumption and the resources to pay for basic manufacturing technology. Another significant effect of this reform was the social and economic mobility that it enabled, which in turn led to the emergence of a new middle class and a new cohort of entrepreneurs. For instance, the founder of Hyundai (Chung Ju Yung) in Korea and the founder of Formosa Plastics (Wang Yung Ching) in Taiwan were both sons of farmers.

Step 2 – Export or die (Carrot and stick approach to manufacturing)

As agriculture begins to create a new generation of entrepreneurs, returns from agricultural reforms start to taper off after a decade. The challenge then lies in redirecting entrepreneurial energy towards export-oriented manufacturing instead of services. Manufacturing is preferable to services because significant productivity gains can be achieved with low-skilled workers, and manufactured goods are more freely traded across the world.

Where policy differs from the consensus neo-classical approach is in offering protection to domestic manufacturers in the early stages of a country’s development, in the form of subsidies, while keeping international competition out of the domestic market with high tariffs. In exchange for this protection, domestic firms are required to maintain strict “export discipline.” This means that the more a domestic business exports and competes in the international market, the more subsidies and financing it receives.

A positive side effect of this policy is that businesses in North Asia were compelled to rapidly climb the technology learning curve to produce high-quality products. Those that failed to be export competitive were cut off from cheap credit and subsidies and were forced by the government to shut down or merge with successful companies. Instead of picking winners, the government weeded out the losers.

For example, Korea’s government encouraged a dozen conglomerates, including Samsung, Daewoo and Shinjin, to master car manufacturing in a market that was just 30,000 units in size. Vehicle imports were prohibited until 1988 and the import of Japanese cars until 1998, allowing domestic manufacturers to compete for survival. As a result of this policy, a single world-beating colossus in the form of Hyundai-Kia remains.

In contrast, Malaysia decided to master car manufacturing with a single state-owned enterprise (Proton) instead of encouraging private enterprise. With no export discipline or internal development of technology, Proton has mostly found success in the domestic market. In 2022, Proton sold approximately 141,000 cars, while Hyundai Kia sold over 6.8 million.

Step 3 – Targeted finance (Saying no to short-term profits)

The final step is to ensure that domestic financial institutions are fully aligned with the agricultural and industrial policy goals outlined above. Banks are kept under government control via the central bank and “directed” to lend to industrial and agricultural projects that may not necessarily yield the highest short-term returns but have the potential to earn long-term profits by nurturing infant industries. Capital controls are implemented to ensure that citizens’ savings remain in the country to finance national development projects.

The key is to avoid premature deregulation of the financial sector as with what led to the 1997 Asian financial crisis. Deregulation and capital market development as promoted by the World Bank and International Monetary Fund came much later in the industrialization process in Taiwan and Korea. In South Asia, premature deregulation of the financial system led to the issuance of new bank licenses to a cozy group of entrepreneurs who financed their own business activities and short-term speculative investments, like luxury real estate, instead of projects of national importance.

This historic review of North Asian success may seem both contrarian and counterintuitive due to its prescription of financial repression, tariffs and political intervention. However, it helps us at Global Alpha identify countries or sectors that might be on an unconventional path to success. For example, when we were in Vietnam late last year, we couldn’t help but wonder if its combination of an export-driven model and capital controls resembles the Korea or Taiwan of 1970s and 1980s.

Similarly, when Korea announced in 2022 its plans to develop its carbon composite industry as its second steel industry, we saw parallels with how it mastered the art of steelmaking with POSCO, now one of the world’s most efficient steelmakers. In fact, we have exposure to the advanced materials space in Korea through Hansol Chemical (014680 KS), which plans to invest ₩85 billion in silicon anode production as a solution to increasing the energy density of EV batteries while reducing charging time. If history is any guide, we can expect plenty of support from the Korean government to nurture this industry of the future.

Macro awareness can help you succeed

The success of emerging markets isn’t just about individual companies, but also about the broader economic and political context in which they operate. Being macro aware and having a solid understanding of the broader context can help investors make better informed decisions, mitigate potential risks and maximize their returns.

A green and yellow motorized rickshaw zips through the streets of Delhi, India

Since the World Bank’s International Finance Corporation first coined the term emerging markets in 1981, the characteristics and composition of the markets have evolved significantly. Past concerns regarding the resilience of emerging markets during a crisis led some investors to struggle with the merits of including a direct allocation. However, with the rise of China and its leadership of global economic growth, investors are increasingly considering a dedicated allocation to emerging markets. This article reviews the evolution and the general case for investing in emerging markets.

The key attributes supporting the case for global emerging markets have been evident for some time and include:

Greater growth In the latest Global Economic Prospects report by The World Bank Group, emerging and developing economies are forecast to grow more than double that of advanced economies in 2023 and 2024.
Drivers of Innovation Many emerging markets companies have become leaders of innovation in important sectors such as internet-related technologies, electric vehicle battery manufacturing, and computer chip manufacturing.
Household names Many emerging market companies are household names such as Samsung and Hyundai, while other less recognized companies have acquired well-known global brands.
Rising returns As emerging markets shift from manufacturing to more value-added industries, there is an expectation for the ability to generate superior returns to rise.
Alpha opportunities Emerging markets are less researched by the analyst community compared with large cap developed equity markets, which creates opportunities for excess returns from independent research by active managers.

 

 Background

Emerging markets are characterized as countries with growing economies and a growing middle-class population. Many of these markets continue to have high rates of poverty, and often they are still experiencing significant social and political change. But despite such headwinds, the growth prospects of emerging markets can provide a strong base for investors to be rewarded.

The market capitalization of emerging markets was US$ 90,456 billion as of December 31, 2022, representing a little over 11% of the world equity capitalization. Yet many institutional investors have no direct exposure to emerging markets. Instead, investors often rely on their international and global equity managers to selectively invest in emerging markets, which can result in the allocation falling well short of its representation of the world equity market capitalization. With emerging markets representing the highest growth area of global stock markets, there is a case for investors to benefit from at least a market representation.

The MSCI Emerging Markets Index is comprised of over 1,300 stocks in 24 countries. Countries are normally grouped into three regions, Emerging Markets Asia, Emerging Markets Latin America and Emerging Markets Europe, Middle East and Africa, with the Asian region representing almost 80% of the market index.

Evolution

For the longest time emerging markets were considered similar to the Canadian equity market, with a heavy bias to commodities. Today, the combined weighting in energy and materials for emerging markets is less than 13% of the index market capitalization, compared to 30% of the Canadian equity market. Instead, emerging markets have evolved to offer opportunities different to the Canadian equity market. For example, emerging markets have experienced a steady rise in the information technology and health care sector allocations, which together represent over 20% of the market index (Figure 1). Not only that, but within the information technology sector there has also been a radical change in its composition with large and successful companies, such as Alibaba and Tencent making up an important component of the sector.

Figure 1: Index Sector Allocations

Global Industry Classification (GIC) Sector MSCI Emerging Markets (%) S&P/TSX Composite (%)
Energy 5.0 18.1
Materials 7.6 12.0
Industrials 19.4 13.3
Consumer Discretionary 12.5 3.7
Consumer Staples 4.7 4.2
Health Care 10.7 0.4
Financials 14.3 30.8
Information Technology 10.8 5.7
Communication Services 2.8 4.9
Utilities 3.2 4.4
Real Estate 8.9 2.6

 

Source: Thomson Reuters Datastream. Data as of December 31, 2022. Due to rounding, column percentages may not total 100%.

The financial sector represents around 14% of the index and offers a further differentiation versus developed markets, where the loan-to-deposit ratios in emerging market companies are generally lower.

However, the biggest change to the emerging market index has been with respect to country allocation, and the growing dominance of China in the index. It was not long ago that large cap China A shares represented less than 1% of the MSCI Emerging Markets Index. At the end of 2022, China accounted for over 32% of the index (Figure 2).

Figure 2: Region and Larger Country Allocations

Region and Country MSCI Emerging Markets Index (%)
Emerging Markets Asia 78.3
China 32.3
India 14.4
Taiwan 13.8
Republic of Korea 11.3
Emerging Markets Europe, Middle East & Africa 13.2
Saudi Arabia 4.1
United Arab Emirates 1.4
Qatar 1.0
Kuwait 0.9
South Africa 3.7
Emerging Markets Latin America 8.5
Brazil 5.3
Mexico 2.3

 

Understanding the Risks

It is important to appreciate risks associated with investing in emerging markets. While active managers can mitigate some of these risks through research and careful selection of individual stocks, investors should recognize the following.

  • Political and social risk: Political and social changes taking place in emerging market countries can lead to uncertainty due to corruption, regulations not always being rigorously enforced, or governments exhibiting an unwanted influence. The uncertainty contributes to market volatility. For example, Beijing’s actions to limit the influence of Hong Kong-listed technology companies, combined with a real estate sector crisis and the zero-COVID policies that witnessed longer strict pandemic controls relative to most other governments, contributed to a tough and volatile 2021-2022 for emerging market equities.
  • Information and liquidity risk: Although the quality of data has vastly improved, obtaining good, complete and timely information can still be challenging in emerging markets. Currency controls remaining in a small number of markets also may create liquidity concerns.

Recognizing the potential benefits

While the countries are classified as emerging, nearly all the companies in the MSCI Emerging Markets Index have a market capitalization greater than US$ 1 billion, which compares to 209 Canadian companies with a market value above US$ 1 billion. Increasingly, emerging market companies are becoming household names, whether on their own merits, or through acquisition of global branded companies, such as Samsung, Hyundai Motor and the Indian conglomerate, Tata, which is the owner of brands such as Jaguar, Land Rover and Tetley Tea.

The key benefits offered by emerging markets include:

  • Growth opportunity: The drivers of growth are wide ranging and include demographics, economic development, technology, innovation, infrastructure development, and capital market developments. While global growth is expected to moderate from 2021 levels, emerging and developing countries are expected to account for a significant component of world gross domestic product (GDP). The World Bank forecasts emerging and developing markets to grow at an average annual rate of 3.4% in 2023 and 4.1% in 2024, compared to expansion of only 0.5% and 1.6%, respectively for advanced (developed) economies.1 A significant proportion of developed market company earnings are also linked to emerging market growth, further underlining its importance.
  • Drivers of innovation: Innovation in emerging markets has contributed to its evolution, as well as China becoming an important component of the market. Innovation has allowed several emerging market countries to leapfrog the developed world in terms of business models. For example, while many farmers in India have no access to computers and landlines, smart phones have created an information and business environment that allows buyers and sellers to interact, as well as enabling e-payments.
  • Rerating opportunity: Ordinarily, high-growth assets are priced at a premium. Emerging market stocks have traditionally traded at a discount to developed world valuations, but the economic fundamentals for emerging markets as a whole have improved.
  • Improving returns: Many emerging market companies are shifting away from manufacturing for Western companies and looking to develop their own identity and growth success. To achieve this they are tapping into higher value-added areas using brands and technology, recognizing that branded firms with loyal followers can achieve more than double the margins of non-brand firms. Return on invested capital (ROIC) should rise for emerging market companies as they develop world-class brands.
  • Growing universe of opportunities: The growth of China in the emerging market index has also witnessed a growth in the universe of investment opportunities. Today, there are as many China A shares that meet the typical liquidity and market capitalization criteria as there are in the United States (US) equity market. Similarly, the number of opportunities for emerging markets excluding China is not too different from the number of opportunities for the global developed market, excluding the US.
  • Style offset opportunity: The growing opportunity set has witnessed a growth in systematic (quantitative) fund offerings, where the managers use technology to gain a breadth of understanding on a large universe of companies, compared to the depth of understanding associated with fundamental managers focused on selecting a smaller portfolio of companies. As for other equity markets, investors who can accommodate multiple managers in an asset class can benefit from the complementary approaches of systematic and fundamental styles.
  • Alpha opportunity: The external analyst community generally undertakes less research of emerging market companies compared to global developed companies. Active managers have been able to benefit from independent research with over 86% of managers in the emerging market equity universe outperforming the MSCI Emerging Market Index over the 10 years ended December 31, 2021 (based on the eVestment database).

Environmental, Social and Governance Considerations (ESG)

Despite the political and social challenges associated with emerging market countries, companies are increasingly recognizing the importance of ESG considerations. Helping this cause has been the expansion of ESG coverage of emerging markets companies by third-party providers. The importance of each ESG component varies from one country, industry or company to another. However, like the developed world, corporate governance tends to be the most material issue, followed by the steps being taken to manage the environmental impact of companies in the emerging markets.

The Case for Emerging Markets

Many investors are underweight emerging markets relative to its representation in world equity markets, yet global growth is expected to be led by emerging and other developing markets.

Canadian investors have historically shied away from emerging markets, partly due to the historical commodity bias. Today, emerging markets offer a very different opportunity set due to innovation that has seen a transformation in the type of companies and opportunities, including a significant growth in the information technology sector.

As emerging market companies shift from manufacturing to higher value-added interests using brands and technology, the number of emerging market household names will increase, and help to grow margins and ultimately the return potential from emerging markets.

1 Source: World Bank Global Economic Prospects, January 2023

Man looking ahead at the Shanghai skyline.

Summary

  • Emerging market equities notched a positive month despite the fears over cracks appearing in developed market banking systems with the failure of Signature Bank, Silicon Valley Bank and the UBS takeover of Credit Suisse.
  • Chinese equities steadied in March, slightly up as the two sessions (China’s equivalent of parliament) rubber stamped Xi’s unprecedented third term as leader, and Li Qiang’s ascent to the role of Premier. Li was keen to tout China’s business-friendly credentials in his first remarks as premier.
  • This was followed later in the month by Jack Ma’s return to Hangzhou, China, the home of Alibaba HQ. This was followed shortly after by an announcement by the company that it would be split into six units. According to Alibaba CEO Daniel Zhang, the units will be able to “pursue independent fundraising and IPOs when they are ready.”
  • This provided a major boost to large cap Chinese tech stocks, with investors interpreting the announcement as further confirmation that regulatory headwinds for the sector were easing.
  • Portfolio names Alibaba, Tencent and Netease all rallied sharply.
  • Stocks in Taiwan and South Korea were stronger, in part due to some optimism that the deep downcycle across the semiconductor industry is starting to bottom.
  • Brazil underperformed wider emerging markets. Despite falling inflation and scope for the central bank to consider rate cuts, political risks continue to curb investor enthusiasm. President Lula’s scepticism of central bank independence and a free spending fiscal agenda are key concerns which muddle a potentially compelling opportunity for investors.
  • Gulf markets were weak, as headwinds build for energy prices and other commodities given the deteriorating global economic outlook.

Navigating booms and busts in China

Given the wide dispersion of country returns in emerging market equities each year, we know that outperformance hinges on finding the right stock in the right country. As the below chart illustrates, great stock fundamentals can be wiped out by poor macro.

Dispersion of EM country returns

Chart 1: Emerging market returns by country from 2004 to 2022.
Source: Thomson Datastream.

The opportunity to gain exposure to high-quality companies operating in an economy delivering structural outperformance – such as India at present – is a key attraction of emerging market equities. However, experience teaches us that it is through avoiding big negative macro shocks in EM that we can sustainably tilt the odds in our favour.

Our approach to country analysis centres on two elements: 1) hard data inputs with monetary aggregates at the heart of this; and 2) qualitative macro analysis incorporating an assessment of shorter-term factors such as political risk and longer-term structural factors like institutional quality.

This piece will focus on the quantitative element, and specifically the role that the Liquidity Theory of Asset Prices plays in country selection.

Emerging markets and the Liquidity Theory of Asset Prices

Analysis of monetary (or liquidity) data is a key input in our process for determining country weightings. This is based on the insight that, while we know that monetary trends lead the economy, “excess” money – the difference between the growth of real money supply and industrial output – moves markets even earlier. Broadly speaking, when narrow money is growing above industrial production, you are probably in a bull market somewhere as money not put to use in the real economy finds its way into bonds, stocks, property and other assets. The reverse also applies, with current weakness in financial markets reflecting a deteriorating liquidity picture as hot inflation and tight monetary policy suck money out of markets.

G7 + E7 industrial output & real narrow money (% 6m)

Chart 2: Graph showing G7 and E7 industrial output relative to real narrow money from 2000 to 2022.
Source: Thomson Datastream.

Applying Liquidity Theory in EM equities

We have found this to be a powerful leading indicator and tool for assessing the optimal country exposure through economic and market cycles. In emerging markets this works particularly well as we analyse liquidity country by country in a wide and diverse opportunity set.

Over the decades our team has compiled data on the sensitivity of individual countries in EM to varying liquidity environments. This helps us gauge whether the tide is coming out or in for a country’s financial markets. While this data provides signals for which markets might be winners over the medium term, we find that it adds the most value in providing warning signs of vulnerabilities that precipitate market shocks. You do not want to be around in a country like Argentina or Turkey when the liquidity tap shuts off.

Key input for managing China exposure

Liquidity analysis has been central to managing our portfolio exposure in China. As the chart illustrates below, observing the change in real narrow money growth is a key input for anticipating periods of out- or underperformance for the largest component of the EM benchmark. This is married up with qualitative macroeconomic research and in-depth economic value added stock analysis to determine exposure that aligns with our level of conviction.

MSCI China price index relative to MSCI EM & NS Partners’ active weight in China + Hong Kong

Chart 3: MSCI China Price Index relative to MSCI Emerging Markets Index and NS Partners’ active weight in China and Hong Kong from 2014 to 2022.
Source: Thomson Datastream.

Successfully navigating the violent boom and bust of Chinese equities from 2014 through to mid-2016 demonstrates the effectiveness of this approach. Improving narrow money through the beginning of 2014 preceded a lift in exposure to China as the market began to outperform. Conversely, money numbers deteriorated from mid-2014, a warning sign that the rally was on borrowed time. This formed part of our decision to begin cutting exposure ahead of the market peak in June 2015. Highly leveraged retail investors had fuelled the final euphoric stages of the rally. News of a softening economy saw sentiment for Chinese equities wane, with initial modest stock declines triggering a wave of margin calls that precipitated a frenzied sell-off.

CSI 300 index (rebased to 100)

Chart 4: CSI 300 Index performance from 2014 to 2016.
Source: Bloomberg.

Fearing the slump would trigger a major financial crisis, Chinese authorities stepped in to introduce short selling bans and stock “circuit breakers”, while loosening margin requirements to allay fears of further defaults. Lock-up periods were enforced for owners of more than 5% of a company’s tradeable stock, and mutual funds and pension funds were compelled to support the market. Critically, the PBoC stepped in to slash rates, providing a significant boost to money numbers. Sentiment remained fragile through the beginning of 2016 with investors concerned about the ability of Beijing to rebalance a structurally slowing economy with bad debts without triggering capital flight. We were more constructive than consensus and gradually lifted exposure to overweight, encouraged by money numbers signalling a stronger economy ahead and judging that authorities had the tools to keep forex and balance of payments risks in check.

More recently, having been significantly underweight through the brutal selloff in Chinese equities in 2021, we began lifting exposure at the end of that year in response to improving liquidity data, reaching a neutral weight by the middle of 2022. This was subsequently raised to overweight later in the year as money numbers improved further, some political headwinds eased and Beijing’s COVID-zero approach to the pandemic was rapidly abandoned. The weighting shift provided a boost to portfolio performance as Chinese equities rallied hard on the “reopening trade”.

CSI 300 & HSI index (rebased to 100)

Chart 5: CSI 300 and HSI Index performance from 2018 to 2022.
Source: Bloomberg.

Looking ahead, we remain modestly bullish on Chinese equities but believe that current monetary trends signal that the authorities are determined to avoid overstimulating and sparking a Western-style inflation surge, which would risk social disruption. This should support a gradual but more sustainable economic recovery favouring quality names, as opposed to more cyclical parts of the market and derivative plays in materials and energy. 

As outlined above, in addition to quantitative inputs to our process, we also consider shorter term political risks along with longer term measures of institutional quality. China faces major challenges on both of these fronts as the Sino-U.S. dispute intensifies and as Xi Jinping consolidates power at the expense of the intra-party pluralism established under Deng Xiaoping. It means that while a monetary and economic recovery provides a supportive backdrop, our qualitative assessment of political and policy risks limits our conviction and consequent portfolio exposure to China.