Beyond the dragon’s reach

Despite their classification, EMs are less homogenous than their developed market counterparts. EMs are at different stages of growth, with diverse demographics, structural tailwinds, and policy priorities. EMs 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 expenditures.

The integration of EMs into global capital markets is not uniform. However, it’s evolving as individual capital markets open up more to international investors and become increasingly sophisticated.

As an asset class, EMs remain underrepresented in global markets. EM equities account for around 11% of the free-float weighted equity market (MSCI All Country World Index) [2]. At the same time, Chinese equities remain underrepresented in global indices relative to the country’s economic influence.

China’s influence on EMs

China is the largest country driving EM performance and could become even more dominant over the coming decades. In 2018, MSCI started to include China A-shares – stocks that trade on domestic exchanges on the mainland – into the EM Index. Today, China’s weight on the index is around 24.4%. Although it has come down from around 30% last year due to the sharp sell-off in the market, it is still significantly ahead of the likes of India (19.9%) and Taiwan (18.8%) (Chart 2) [4]. 

Why EM ex-China?

The opportunity set outside of China is blossoming (Chart 4).

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-on-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 whom are young. India has recently become the world’s most populous country, with a median age of 28. This compares to China (39) and the US (38). India is also the world’s third-largest consumer market, behind the US and China. At the same time, the populations of large countries like Indonesia and Brazil are growing [5].

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

The rapid proliferation of digital technologies, underpinned by an abundance of smartphones and affordable internet, has caused a seismic shift in consumer behaviour patterns. This has created 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 (Chart 7).

Global technology drivers

Digitalisation has become an important growth driver for emerging economies in the last decade. Technology is allowing EMs to catch up more quickly 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 in the prominence of many Chinese internet and fintech businesses.

However, numerous EM ex-China companies are helping shape 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). Semiconductors are a burgeoning industry. By 2030, the sector is expected to grow to US$1 trillion – averaging 6% to 8% growth annually [6].

Digital transformation initiatives in the wake of the pandemic are also stimulating demand for IT outsourcing services. Companies worldwide 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 also compete in this space.

Supply chain diversification and nearshoring

US-China trade tensions, pandemic-related disruptions, and a substantial rise in Chinese wages are encouraging corporations to diversify their supply chains. By adopting a ‘China plus-one’ strategy, many are moving parts of their operations out of China and into EM countries with attractive demographics, low production costs, and relative political stability.

Numerous countries in the EM ex-China universe fit the bill, including India, Vietnam, Thailand, Indonesia, Mexico, and Malaysia. They’ve all 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), favourable corporate tax structures, and better domestic infrastructure. For example, a Taiwanese multinational electronics manufacturer – Apple’s main supplier – reportedly plans to invest nearly US$500 million to build two component factories in India, as part of its efforts to diversify away from China [7].

Furthermore, several US companies are setting up production closer to home. Mexico is a notable beneficiary of this ‘nearshoring’ trend, thanks to its proximity to the US, competitive labour costs, and favourable tax conditions (Chart 8).

Additionally, manufacturing wages in Mexico have remained steady over the last decades, at a little over US$2 an hour. This compares favourably to China, where average wages have increased threefold to around US$6 an hour over the same period [9].

The green transition and abundance of commodities

Many EM countries are endowed with vast natural resources, which makes their economies closely linked to commodity prices. Exporters in Latin America and South Africa should benefit from long-term global decarbonisation efforts. Over the short-to-medium term, Middle Eastern oil will still be needed, while nations and companies seek to build the green infrastructure of tomorrow.

In its early stages, the energy transition is leading to 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 (Chart 10).

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

What does the universe look like?

The EM ex-China equity 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 single country or sector dominates the benchmark, with increased weightings for several smaller EMs, such as Brazil and Saudi Arabia.

Final thoughts

EM ex-China is at an inflection point. EM equities have performed below their potential for over a decade, struggling against external pressures, such as currency fluctuations and debt. However, conditions are improving, helped by robust reforms and better macro management.

Additionally, external balances and government debt are improving, as are currency dynamics. Meanwhile, capital markets have deepened and become more sophisticated. Digitalisation and innovation are creating seismic shifts in consumption patterns and business models. Many previously unappealing EM regions like the Middle East are slowly becoming attractive investment destinations. All of this is helping to transform emerging economies, and this is also gradually being reflected in corporate performance.

What does all this mean for China? The country’s meteoric rise has overshadowed EM for over two decades. Increasingly, however, clients want more control over their exposure to China and its associated risks. We therefore believe there’s merit in having a separate active EM-ex China strategy, combined with a separate, dedicated active strategy for China, which remains a fertile hunting ground for long-term, fundamentally driven investors.