EM have become a powerhouse of the global economy, contributing around 59% of the total world GDP (based on PPP terms – Chart 1). This growth is underpinned by a young, expanding and increasingly wealthy middle class. Over the last decade, China was primarily responsible for EM's growing influence. However, we think this is about to change, as EMs outside China rapidly catch up and exert their economic and political influence on the international stage.

Source: International Monetary Fund, July 2023.

Investors are debating whether to split their EM allocations into China and ex-China strategies. The goal is to better manage their China risk, while also seeking attractive EM investments outside the world's second-largest economy.

Despite their classification, EM are less homogenous than their developed market counterparts. Emerging economies are at different stages of growth, with diverse demographics, structural tailwinds and policy priorities. EM manufacture most of the world's goods – from high-end semiconductors to food staples like coffee, tea, and cereals. They're also resource-rich, supplying the world with much of its oil and raw materials. Meanwhile, EM companies are expanding their global presence through innovation and often turn to public markets to raise funds for capital expenditure. The integration of EM into global capital markets is not uniform. However, it's evolving as individual capital markets open to international investors and, in the process, become more sophisticated. As an asset class, EM remains under-represented in global markets. EM equities are around 11% of the free-float weighted equity market (MSCI All Country World Index).¹ At the same time, Chinese equities remain underrepresented in global indices relative to the country's global economic influence.

EM ex-China has a large market capitalization, offering depth and liquidity. As of end-July 2023, EM ex-China accounted for almost half of the constituents on the MSCI EM Index (708 out of 1,421 stocks), but the total investable universe is much bigger.² We believe structural opportunities in EM ex-China offer significant alpha generation potential.

China's influence on EMs

China is the largest country driving EM performance and is set to become more dominant over the coming decades. In 2018, MSCI started to include China A shares – stocks that trade on domestic exchanges on the mainland – in the EM Index. China A-shares currently account for 20% of the index, while the combined weight of offshore and onshore China is around 30%. According to estimates, the full inclusion of A-shares would result in China representing around 41% of the EM Index.

Source: MSCI, August 2023.

China remains a fertile hunting ground for long-term, fundamentally driven investors. However, geopolitics remains a concern, while domestic policy can create heightened volatility. Investors, as a result, want more control over their China exposures.

By contrast, EM ex-China investments are subject to less top-down scrutiny. Over the past decade, domestic economic policies have become more orthodox. The influence of these policies is evident in the correlation in performance between the MSCI EM Index and the MSCI EM ex-China Index in recent years. Returns have diverged (Chart 3), particularly since the pandemic when Beijing's policies frequently dictated market sentiment.

Source: Bloomberg, August 2023.

We believe there's merit in a separate, active EM ex-China strategy. Many global investors already have a direct allocation to China. EM strategies that include China would therefore double their exposure to the market. An EM ex-China strategy could offer portfolio diversification through attractive opportunities elsewhere within the asset class. It also means investors can separately manage their China exposures and risk.

Why EM ex-China?

The opportunity set outside of China is blossoming (Figure 1). Demographic and structural tailwinds are underpinning alpha-generation prospects in high-growth markets. There's a breadth of high-quality listed companies spread across EM ex-China, with solid fundamentals and attractive valuations. The list is endless, from Taiwanese chipmakers and South American copper producers to Middle Eastern oil companies and Indian lenders and insurers. A growing number of companies are also becoming global leaders in areas such as technology (see below).

Source: MSCI, July 2023.

Structural tailwinds

Several long-term structural drivers provide a tailwind for EM ex-China. This growth story frequently gets lost in the noise of quarter-and-quarter or year-on-year relative returns.

Consumption growth

Emerging and developing economies (ex-China) are home to some 5.4 billion people, most of them young. India has recently become the world's most populous country, with a median age of 28. This compares to China (median age 39) and the US (38). India is also the world's third-largest consumer market behind the US and China. At the same time, large countries like Indonesia and Brazil's populations are growing.³

Better macro management in EM ex-China is further supporting consumption growth. While the potential of EM is well known, domestic economies have struggled as external pressures buffeted consumers via currency fluctuations, inflation, and debt. Today, the currency dynamics for EM look favorable. External balances and government debt are in better shape. Meanwhile, domestic reforms, innovation and urbanization are pushing consumers into higher-income employment. Digitalization is creating new opportunities and driving faster economic growth. Combined, these set the stage for domestic consumption to flourish.

Source: Morgan Stanley Research, August 2023.

The rapid proliferation of digital technologies, underpinned by an abundance of smartphones and affordable internet, has caused a seismic shift in consumer behavior patterns – creating new economic sectors such as e-commerce. We've seen some of the biggest shifts in offline-to-online retail in India, Southeast Asia, Taiwan, and Latin America.

Global technology drivers

In the last decade, digitalization has become an important growth driver for emerging economies. Technology is allowing EM to catch up with developed markets. Competitiveness and innovation across industries have grown – from automation to electric vehicles to renewables. Much of this can be attributed to the dramatic rise to prominence of many Chinese internet and fintech businesses. However, numerous EM ex-China companies are shaping the next phase of the digital revolution. This includes many of the world's leading manufacturers of semiconductors – those vital chips used in laptops, smartphones, cars, industrial equipment, high-performance computing, and more. Semiconductors are also driving the megatrends of the future, notably 5G and AI (artificial intelligence). This is a burgeoning industry. By 2030, it's expected to grow to US$1 trillion – averaging from 6% to 8% growth a year.⁴

This overall technological shift is reflected in the MSCI EM ex-China Index, where information technology has the highest sector weight (26.85%). By contrast, financials dominate the EM Index (21.79%).

Digital transformation initiatives in the wake of the pandemic are also stimulating demand for IT outsourcing services. Companies around the world are competing for tech talent, while trying to keep a lid on operating costs. This is creating opportunities for EM ex-China firms, particularly in India. The country remains the go-to destination for IT outsourcing thanks to exceptional cost advantages, a large English-speaking talent base and skilled competencies that have been developed and fine-tuned over the last three decades. Latin America, Eastern Europe, and the rest of Emerging Asia are also competing in this space.

Supply chain diversification and nearshoring

US-China trade tensions, COVID-related disruptions and a substantial rise in Chinese wages have caused corporates to diversify their supply chains. Adopting a China plus-one strategy, many are moving parts of their operations out of China and into EM countries with similar demographics, low production costs, and relative political stability.

Source: J.P. Morgan, June 2023.

Source: J.P. Morgan, June 2023.

Numerous countries in the EM ex-China universe fit the bill, including India, Vietnam, Thailand, Indonesia, Mexico, and Malaysia. They've put forth plans to attract foreign direct investments from multinational companies. Initiatives include improving the ease of doing business, production-linked incentive schemes (as seen in India), favorable corporate tax structures, and better domestic infrastructure. For example, a Taiwanese multinational electronics manufacturer – Apple's main supplier – is reportedly planning to invest nearly US$500 million to build two component factories in India as part of its diversification efforts away from China.⁵

Furthermore, several US companies are setting up production closer to home. Mexico is a notable beneficiary of this nearshoring thanks to its proximity to the US, competitive labor costs and favorable tax conditions. Indeed, many car manufacturers that sell in the US have factories in Mexico. In March, for example, a Texas electric vehicle company announced it would build its next Gigafactory in Mexico (chart 5).⁶ Additionally, manufacturing wages in Mexico have remained steady over the last decades, at a little over US$2 an hour. This compares favorably to China, where wages have increased threefold over the same period, to around US$6 an hour.⁷

Abundance of commodities

Many EM countries are endowed with natural resources, which makes their economies closely linked to commodity prices. Exporters in Latin America and South Africa should benefit from long-term global decarbonization efforts. Over the short-to-medium term, Middle Eastern oil will still be needed while nations and companies build the green infrastructure of tomorrow. While in the early stages, the energy transition is leading to an increased demand for raw materials such as lithium and copper – both essential for electric vehicles, among other things. Latin America is the largest producer of these materials by region.

At the same time, capital flows into the Middle East are creating new opportunities outside energy. Many countries have enacted comprehensive reforms to transform their economies and diversify away from energy. Take Saudi Arabia and its Vision 2030. Here, there's been a concerted effort to attract international investors, creating opportunities in areas like consumption and other structural compounders that were previously unavailable.

What does the universe look like?

The EM ex-China universe not only gives exposure to other high-growth markets, but also access to companies driving economic growth across various sectors. Unlike the MSCI EM Index, no one country or sector dominates the benchmark (Chart 8).

At the country level, Taiwan, India, and South Korea each account for around or less than 20% of the MSCI EM ex-China Index. Brazil and Saudi Arabia also have significantly bigger weights in the index than compared with the MSCI EM Index.

Source: MSCI, August 2023.

At the sector level, Information Technology and Financials are the largest in both indices. Consumer sectors, however, are a bigger part of the MSCI EM Index, in part due to China, whereas the ex-China index has a larger weight towards Materials and Industrials.

Source: MSCI, August 2023.

Final thoughts

EM ex-China is at an inflexion point. For over a decade, EM have performed below their potential, struggling against external pressures such as currency fluctuations and debt. Following robust reforms and better macro management, conditions have turned positive for the asset class. The currency dynamics look better. External balances and government debt are improving. Meanwhile, capital markets have deepened and grown more sophisticated. Long term, digitalization and innovation are creating seismic shifts in consumption patterns and business models. Many previously unappealing EM regions, such as the Middle East, are slowly morphing into attractive investment opportunities. All of this is helping to transform emerging economies. It's also gradually reflected the asset class's performance.

What does this mean for China? The country's meteoric rise has overshadowed EM for over two decades. Increasingly, however, clients want more control over their China exposure and risk. We therefore believe there's merit in having a separate, active China strategy – which remains a fertile hunting ground for long-term, fundamentally driven investors.

¹ Bloomberg, July 2023.
² Bloomberg, July 2023.
³ International Monetary Fund, July 2023.
⁴ McKinsey & Company, “The semiconductor decade: A trillion-dollar industry.” April 2022
⁵ Bloomberg, “Apple supplier Foxconn plans $500 million component plants in India,” July 2023.
⁶ The Verge, “Tesla confirms its next Gigafactory will be in Mexico,” March 2023.
⁷ Quartz, “As China's wages rise, Mexico beckons manufacturers,” November 2022.

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