Chinese turbulence batters emerging market equities

Emerging markets (EM) have not had things easy. The impact of Covid-19 may have been felt globally, but, while developed markets have, in general, managed to successfully roll-out the vaccines which promise a way out of the health crisis, EM have lagged behind and recovery has therefore been slower. 

Added to this are events in China, which dominates the index. While property developer Evergrande battles huge levels of debt, putting global financial markets on high alert, increased levels of regulation, in particular against the tech giants, as well as in the after school tuition sector, have made the country a less attractive story for some investors.

More than meets the eye

Although year to date, the MSCI EM index has returned -1.25 per cent, this does not tell the whole story, argues Edward Evans, emerging and frontier equities portfolio manager at Ashmore Group.

“Weak performance from China (which fell -16.7 cent) pulled the broader EM index lower, with MSCI EM ex China returning 8.8 per cent, only modestly behind developed markets,” he reports. 

Indeed, the heterogeneous nature of EM was in evidence with India, Taiwan and Russia all enjoying notably strong performance, up 26.5, 16.3, and 31.1 per cent respectively, as did the small cap and frontier markets indices. 

“The inefficient nature of EM was also on display with the volatile market backdrop leading to ample alpha generation opportunities,” he adds.

The response to the pandemic is now heading in the right direction, says Mr Evans, as after a slow start, improved vaccine procurement and effective deployment mean EM are starting to catch up with their developed market peers. 

“The pace of vaccination has improved across the board, which should trigger a rebound in business confidence, investment and improve the transmission of policy support,” he says, though cautions that excitement over the vaccine should be tempered by the possible emergence of more virulent variants.

Since late 2020, China has followed a programme of increased regulation and reform. In response,   the market has applied a higher equity risk premium, given concerns that Beijing is introducing market unfriendly policies and is targeting companies with supernormal profits. Yet, taken as a whole, Mr Evans believes the policy steps are constructive and should help underpin a sustainable domestic economic growth trajectory in the country. 

“The measures are aligned and focused on ensuring social stability, as well as political control, as the economy continues to grow, develop and transform. This is consistent with previous policy measures,” he says, expecting the “regulatory overhang” to prove transitory. 

“This period may therefore provide, selectively, excellent investment opportunities, especially for those segments of the market and stocks caught in selling pressure despite little change to their fundamental underlying drivers,” adds Mr Evans.

Not unexpected

No one who follows China should have been surprised that the Chinese government would do some of the things it has done, says Gary Greenberg, head of global emerging markets at Federated Hermes International. It is a top-down economy where the importance of the ruling Communist party is paramount. 

As such, investors have to take more notice of the government in China than they would do in other countries, and even more so now than they might have done at other times, he says. “People say China has become uninvestible, but we don’t think so. You just have to read the tea leaves carefully as to what the government is in favour of and what they want to de-emphasise,” explains Mr Greenberg.

It is the very nature of the Chinese economy that has made some of the recent policy shifts such big news. For example, when the government decided that the tutoring business should be not for profit, then the value of those businesses obviously imploded, says Damian Bird, head of the emerging markets growth strategy at Polen Capital. 

“If this was to happen in other countries then it wouldn’t happen overnight, there would be a process and potentially compensation,” he says. Though to see the move as part of some kind of anti-foreign capital agenda is missing the point, says Mr Bird, as although there were some large, foreign-listed companies involved, roughly 95 per cent of the sector was independent smaller businesses. 

“So, this was a bigger thing than an anti-foreign capital move, more the government saying  they are prepared to suffer the impairment of private capital, be it foreign or domestic, and tolerate an impairment of people’s careers, in the name of the wider good, which we deem to be that our children spend too much time studying and so we need to make changes to our society,” he says.

Nevertheless, the moves have prompted Polen to lower their exposure to China, from around 40 per cent of the portfolio down to 30 per cent, as risk has gone up. “This doesn’t mean nothing in China is attractive, it just means you have to rebalance your risk framework,” says Mr Bird. 

Yet investors should remember that this is a country of 1.4bn people which is getting considerably richer, is incredibly dynamic and has some great businesses. “There are lots of reasons to be bullish on the Chinese story,” he concludes.

Entry point

In addition, the substantial levels of discount now available in China should be seen as an opportunity, says Paras Anand, CIO, Asia-Pacific, at Fidelity International. Although the levels of regulatory intervention have stepped up this year, this is very much a continuation of an approach that began back in 2017 and was interrupted by Covid. 

“While this wave of regulation has been described by some as making the market more unpredictable, and hence less attractive to global investors, we have also seen the ongoing deregulation and reform of capital markets, which have actually paved the way for more overseas investors to access the domestic Chinese markets,” he says.

It should also be noted that the renminbi has proved very resilient through this period of volatility, which represents a substantial break from the past. 

“This arguably indicates two things,” says Mr Anand. “First, that what we’re seeing is much more a reflection of shorter-term sentiment, rather than something that’s more structural. And also that this policy action may indeed lay the foundations for a more stable, balanced growth profile for the Chinese economy over the coming years.”

Indian appeal

Some of the money that has exited China was not necessarily people abandoning the country, rather taking some profits to put to work elsewhere, believes Laurence Bensafi, deputy head of the emerging markets equity team at RBC Global Asset Management, and much of that went into India.

“For many investors, India is their favourite country from every point of view other than valuation,” she says. “It is the best story in emerging markets in terms of size, there are reforms happening, there is a young, well-educated population, and although it is a small equity market at the moment, there is a lot of potential for huge growth.”

A lack of depth in equity markets put off investors for a long time, explains Ms Bensafi, as a lot of traditional sectors, several banks, and many companies were state-owned. There were really only a handful of consumer names to invest in, which were extremely expensive, she says. 

But things are now changing, with a number of initial public offerings (IPOs) bringing new companies to the market, in new sectors such as technology, while it is also becoming easier to access the market. Yet Ms Bensafi does caution that higher energy prices could prove a major headwind for India, since the country is a major importer, while she will also be keeping one eye on inflation.

Ms Bensafi also notes how the value approach to investing, which her portfolio follows, and which has been out of favour for a long time, has seen “incredible” performance over the past year, with the approach buoyed by news of the Covid vaccines (see View from Morningstar on page 77).

India is at the beginning of a process, says Mr Greenberg at Hermes, as the numbers of IPOs and companies in the new economy grow. “It is the same in India as in the US, where private companies didn’t see the need to go public,” he says.  “But we are going to have a number of interesting IPOs that will make the market less cyclical and less subject to the vagaries of the Indian macro situation, which would be good. You don’t want an economy that is dependent on the quality of the monsoon.”

Climate concerns

There are many challenges which go hand-in-hand with EM investing, climate being a key concern. While climate-related issues are gaining increased attention in developed countries, it is outside the world’s temperate zones that “harsh extremes” are particularly affecting EM companies, says Alastair Reynolds, portfolio manager for global emerging markets at Martin Currie.

“Climate change is the deep water wave that is having the biggest impact on our emerging market strategy at present,” he says. “It’s such an important topic that we explicitly address the impact of climate change on every company we consider for investment. From ice melt up in the polar regions of Russia, down to drought conditions in the deserts of South America, climate change is already having a meaningful impact on our company investment decisions.”

This can lead to opportunities. Decarbonisation of the economy is likely to be a key investment theme as the world attempts to lessen the man-made contribution to global warming, says Mr Reynolds, noting how the firm were “relatively” early investors in the electric vehicle battery industry, while he points to copper as a raw material necessary in the continuing electrification of our energy needs. 

Renewable energy solutions should continue to grow, and a number of EM companies have positioned themselves to be major players. Mr Reynolds expects China to emerge as a global leader in this field.

Globalisation has proved a great boon for EM economies over much of the last 50 years, but looking forward, he expects regional trade patterns to prove more influential in determining the fortunes of EM companies. 

“In the short term, this is likely to be most powerful among pan-Asian franchises, as I expect Asia to remain the most dynamic region on a global basis,” says Mr Reynolds. 

This could also mean companies forgo global expansion in favour of building regional dominance, he says, influencing merger and aquistion activity, while companies could move from global to more regional supply chains, which should be positive for capital goods companies, building materials and industrial real estate.  

VIEW FROM MORNINGSTAR: A challenging year, though value makes a comeback 

Global emerging markets equities are having a challenging 2021. In the year to date through September 2021, the MSCI Emerging Markets Index was down by -1.2 per cent (in dollar terms), well below the MSCI All Country World Index’s 11.1 per cent gain. This is a stark contrast from 2020, when the emerging markets index gained 18.3 per cent, beating the global index’s 16.3 per cent return.

In both years, the main driver of overall results was China, which constituted 34 per cent of the emerging markets index as of September 2021. In 2020, China’s economy and stockmarket bounced back from the coronavirus much faster than most other countries. But investor sentiment deteriorated quickly in 2021, as the Chinese government imposed numerous regulatory measures against its technology and communication giants, including Tencent Holdings, Alibaba Group and Meituan. 

In addition, the government levied new rules that effectively wiped out the business models of popular online-education firms such as TAL Education Group and New Oriental Education & Technology. 

More recently, investors have feared that Chinese real estate giant Evergrande Group may collapse, affecting the broader Chinese economy. Overall, the MSCI China Index declined 15.5 per cent in 2021 through September, causing strategies with significant China exposure to underperform. Among the worst-performing global emerging markets funds in the year-to-date was Magellan, which declined by 15.7 per cent. Magellan’s management team seeks market-leading companies that are financially sound and highly profitable, though it was dragged down this year by struggling Chinese bets, such as Ping An Insurance, Autohome, and Alibaba, each of which declined more than 35 per cent.

But there have been some brighter spots within the asset class. Most notably, value stocks have come back in 2021 after lagging their growth peers in seven of the prior nine calendar years. Indeed, the MSCI Emerging Markets Value Index’s 5.9 per cent gain in 2021 through to September beat the MSCI Emerging Markets Growth Index’s 5.2 per cent loss. 

That helps explain why more valuation-aware managers have led the way this year. One of the top-performing funds in the year to date was Stewart Investors Global Emerging Markets Leaders, which climbed 7.7 per cent. 

Its Edinburgh-based lead manager Tom Prew employs a robust, benchmark-agnostic, and valuation-aware approach culminating in a 40- to 60-stock portfolio with high active share. A preference for franchises with durable business models, high-integrity management teams, and limited regulatory/political oversight leads to a persistent overweighting in India at the expense of China. 

While that stance hurt returns in recent years, particularly as growth-oriented Chinese stocks outperformed, Mr Prew never wavered in his commitment to the approach, contributing to the strategy’s strong relative returns this year. 

Another top performer was Robeco QI Emerging Conservative Equities, which uses a quantitative approach seeking low-risk stocks, leading to a consistent value tilt relative to the broad index.

Andrew Daniels, associate director, equity strategies, manager research at Morningstar