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Emerging Markets: Opportunities Beyond China

Michael Reynal 24-Jun-2024

map, flag and cityscape

There's no denying that China—the world’s second largest economy—continues to face headwinds. But in many cases, global investors incorrectly assume that investing in emerging market (EM) begins and ends with China. Of course China matters, and its actions will always shape the landscape to a large degree. Still, we believe it is important for investors to look beyond China to extract the full diversification and return potential of EM equities.


Headwinds in China…


Any discussion of emerging markets must include the world’s second largest economy. China remains the largest component of the MSCI Emerging Markets Index1 by a wide margin, representing approximately one-quarter of the benchmark as of the first quarter 2024. While that share may be down precipitously from 40% a few years ago, it is important to keep some historical context. Any way you look at it, the meteoric rise of China and its transformation from among the poorest economies to an economic powerhouse has been nothing short of a miracle. This rise has been fueled by a combination of global trade and exports, market-oriented reforms, a rising middle class, and massive infrastructure investments, among other factors.


More recently, however, China has been on a downward trajectory. This has been the result of both a cyclical component from pandemic scarring (insufficient and misdirected policy responses, etc.) and a structural component reflecting a sharp decline in productivity growth, driven by disruptive domestic regulatory changes/interventions (in education tutoring, platform internet, financial services, etc.) that eroded private business confidence. The deterioration in US-China relations has further impacted the growth outlook, and a strong U.S. dollar (USD) has only exacerbated matters.


Global investors are focused on three areas of concern regarding the China investment story: 1) the prolonged property sector contraction, 2) local government debt constraining investment, and 3) headwinds to corporate profitability and consumer confidence from deflation. Until properly addressed, these obstacles will remain impediments to any meaningful return of foreign investment flows into China.


…Tailwinds for Others


The rise of EM ex-China mandates, as well as the predominantly passive flows, continue to illustrate the severity of this negative sentiment. However, alternative approaches exist, and global investors may be able to find intriguing direct and indirect exposures to China where GDP growth is, despite it all, still relatively stable at approximately 5%. Here are a few considerations as to why emerging markets are more than a China story today.


  • India is now estimated to be the fastest-growing major economy in the world (GDP grew by 8.4% in the final quarter of 2023), and many economists believe it will soon pass Japan and Germany. This would make it the third largest economy in the world behind the U.S. and China, respectively. Much of this growth stems from attractive demographics as it is now the largest nation by population, and a young one at that with 40% of people under the age of 25. Prime Minister Narendra Modi wants to elevate India into a developed country within the next 25 years, and it continues to attract foreign investment as a manufacturing alternative to China.
  • Mexico continues to advance on the near-shoring/on-shoring of global supply chains happening in tandem on both sides of the U.S./Mexico border. As U.S. companies struggle to find manufacturing workers at home, many are turning to Mexico as a labor-supply solution. Moreover, Mexico continues to gain market share in U.S. imports, surpassing China as the top U.S. trading partner last year. At the same time, Mexican imports from China have also increased in USD terms, due mostly to a robust Mexican economy.
  • Saudi Arabia is the sixth largest stock market in the MSCI EM benchmark (4.3% of the index) behind Brazil but ahead of Mexico and South Africa. The potential for increasing foreign stock ownership, growth in the non-energy-based segment of the economy, and improving demographics (including more female participation in the labor force) all combine to support a promising growth story.


These are just three potential direct growth beneficiaries of the current Chinese headwinds. There are, however, other indirect ways to play the evolving dynamics in emerging markets as well. For example, South Korea and Taiwan are positioned to benefit from the artificial intelligence proliferation across the broader tech ecosystem, and any consumption recovery in China should also boost Korean discretionary consumption, such as duty free, luxury and cosmetics, autos, and tourism. Meanwhile, Brazil and Chile offer a potentially compelling commodity supply play. 


Although we like to look broadly across all emerging markets, it is worth pointing out that we continue to see opportunities in China driven by bottom-up stock selection, further supported by attractive valuations. Using the MSCI China Index as a proxy for Chinese equities, stocks were trading at roughly 7.6x CAPEas of the end of the first quarter, which is more than two standard deviations below the 10-year average of 11.6x.


Embracing the Diversification


In the end, the most fundamental reasons to maintain dedicated exposure across the emerging markets universe are the most obvious ones: demographic trends, differentiated growth characteristics, and attractive valuations versus their own historical average and developed markets at present. Higher population growth, the rise of the middle class, increasing urbanization, and a young working age all contribute to stronger demographics in emerging markets, which account for an estimated 86% of the world’s population. Moreover, the performance of EM equities is meant to offer diversification for allocators, spreading risk across different regions/sectors and reducing vulnerability to downturns in any single region/market. As always, we continue our search for sustainable, attractive earnings growth purely within the emerging market universe, while closely monitoring geopolitical risk.


1 EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.


2 The CAPE ratio stands for cyclically adjusted price-earnings ratio and is a valuation metric that uses real earnings per share (EPS) over a 10-year period. This eliminates wide fluctuations in corporate profits and often provides for better comparisons.