With emerging market woes hitting headlines, we analyse if China will follow suit…

Emerging markets have been a market darling through 2016 to 2018 with returns of +72% vs. +41% for the S&P500 (excluding dividends). However, that status has been tested through much of 2018, with the iShares MSCI Emerging Markets ETF declining by -20% from its January 2018 peak.

Is this money being fickle with global investors taking profits off the table? It is hard to think of it this way given the news flow in some of these markets – the Turkish Lira crisis, Argentine debt woes and the South African economy falling into a recession being cases in point.

Although these are country specific events, they do indicate uncertainty for the broader emerging market ecosystem to some extent. Specifically, the following core themes seem to be a cause for concern for equity investors in emerging markets:

• Strength in the US$ and rising US interest rates;
• Fear of contagion stemming from the Argentinian Peso crisis & Turkish Lira crisis; and
• Trade wars driving a contraction in global GDP.

US$ strength and rising US interest rates

“The dollar remains the single most important consideration for EM [Emerging Markets] finances.”, says a report from debt ratings company Fitch

 

It is normal for emerging economies to rely on foreign currency debt to fund their economic growth. Couple that with near zero percent interest rates, there is no wonder that developing nations have loaded up on US$ denominated debt since 2008.

(Source – International Monetary Fund)

A double whammy of Fed raising the interest rates and a rise in the US Dollar Index by 8% since February this year has made US$ denominated debt far more expensive to service across emerging market economies. Amidst near term US$ strength there is a record US$200b of emerging country debt due for maturity in 2018.

Fear of contagion stemming from Turkey & Argentina

 “History doesn’t repeat itself but it often rhymes.”, a quote often attributed to Mark Twain

 

Long-time emerging market followers are all too familiar with the concept of contagion, with individual, country-specific events emblematic of broader problems. An example of this was the 1990s when multiple instances of country-specific risks dragged down emerging equity market indices indiscriminately.

(Source – Bloomberg Finance L.P.)

Fast forward to 2018, country-specific events appear to bare a similar impact on emerging equity market returns with the Argentinian debt problems in May 2018 and the Turkish Lira crisis in August 2018 accelerating the selloff in most emerging markets through 2018.

(Source – Bloomberg Finance L.P.)

Trade wars driving a contraction in global GDP

“… if current trade policy threats are realised and business confidence falls as a result, global output could be about 0.5 per cent below current projections by 2020.”, says the IMF in its most recent World Economic Outlook.

 

The current global shift towards protectionism, driven by the United States, is likely to see a hard hit on the GDP of some emerging market nations. The group as a whole are net exporters and have benefitted immensely through globalisation over the past few decades.

JP Morgan’s global economics team has already made a downward revision of its emerging market GDP forecasts and unless the trade war rhetoric subsides, we will not be surprised with further downward revisions.

Should we also head for the exits?

It is no wonder then that we have been thinking about how this impacts us at KIS, not only because of Australia’s exposure to China, but also because of our direct exposure to Chinese equities. Much like other emerging market indices, Chinese equity markets have also seen a sharp decline this year.

However, as is often the case in equity markets, the baby gets thrown out with the bath water! As others run for the exits, it is a good time to zoom out and stick to fundamentals for investment decision making. We remain optimistic on the outlook for China as we see some core differences in its economic strength versus rest of the emerging markets.

Amongst the lowest foreign debt levels

China has the second-lowest level of foreign debt as a % of GDP of emerging market nations. This acts as a much-needed shield from US$ strength.

(Source – Bloomberg Finance L.P.)

China has a massive consumer base

In the last 40 years, the Chinese economy has lifted 800m people out of poverty and is a nation with a rapidly burgeoning middle class. Although not immune from global events, China’s massive consumer base provides a shield against macro events impacting other countries.

Above average GDP growth to continue

We are all too familiar with the argument that China cannot continue to grow at double-digits given the massive base of the economy. However, it still remains an attractive destination relative to other markets, with the IMF forecasting the Chinese GDP to expand by 6.6% vs. 4.9% for emerging markets in 2018.

Should China be clubbed with other emerging markets?

Over the past two decades, China has transformed itself from merely a manufacturing hub into an economy which can go toe to toe with the US in terms of tech innovation. Chinese tech companies have demonstrated that they are no less than their US counterparts. In our view, China deserves its own place and it would be a mistake to club it with other emerging markets.