Article by Reshma Kapadia of Barrons.com
China is the 800-pound panda in any conversation about what is going on in the world today. The nation dominates the headlines, is the most-cited reason for sleeplessness among corporate executives, and puzzles investors daily. China looms particularly large for investors in the emerging markets: It represents an uncomfortably outsize stake in most portfolios. And fund managers are getting nervous.
The challenges are daunting. China is growing at its slowest pace in decades — a slowdown that began before the trade war. In past downturns, Beijing printed massive amounts of money to stimulate the economy, but that has resulted in high government debt that prevents it from taking similar measures now. China has also been bracing for a protracted struggle in the conflict with the U.S. over not just trade, but also technology and geopolitical leadership. To complicate the situation, mass pro-democracy protests in Hong Kong that began in June are still going strong, presenting the biggest threat to Beijing’s power in decades.
Not surprisingly, stock investors are reassessing their China stakes and have pulled $13 billion out of equities this year, according to EPFR Global. Meanwhile, the MSCI Emerging Markets index is increasingly a China play: Nearly a third of its weighting is in China, up from 19% just five years ago.
China’s influence is overpowering. The country is the world’s largest buyer of soybeans and copper, and the biggest oil importer, driving the fortunes of commodity producers in Brazil, Russia, and South Africa. Chinese tourists help bolster the economies of nearby countries, as do China’s trade flows — it trades more with its Asian neighbors than it does with the U.S.
This makes investing in the emerging markets particularly tricky. “You have to say to Mr. Panda: ‘You are lovely and will be around for a long time, but could you stand aside. I want to see who is hiding behind you, ‘ ” says Michael Power, a strategist at Investec Asset Management.
There are 25 other countries in the MSCI index, but emerging markets fund managers need to deviate pretty dramatically from the benchmark to invest meaningfully in trends in these countries — and not overinvest in China. That problem will grow as MSCI adds more Chinese domestic A shares to its index; they now account for 4%, but J.P. Morgan Asset Management expects that to rise to more than 15% as China continues to open its market to foreign investors.
Eventually, investors may demand an MSCI index without China — much as they did an MSCI Asia without Japan after that country’s rise in the 1980s. But, for now, Power says, “If you buy the broad emerging markets index, you are just buying some Peking duck with a bit of dressing from elsewhere — some parsley from Latin America and potatoes from Africa, Eastern Europe, and Russia.”
There are other forces driving emerging market stocks beyond China, such as policy moves, including India’s decision to slash corporate tax rates, and Brazil’s pension reforms. Investment flows play a big role. For instance, Southeast Asia has drawn more foreign direct investment than China over the past five years. And demographic trends have long been crucial to emerging markets; while China’s population of 1.4 billion is certainly big, a billion more live in Southeast Asia (which includes Indonesia, the Philippines, and Thailand) and South Asia (Pakistan and India). Their median age is also younger than China’s, which is aging rapidly and will have 360 million people over the age of 60 by 2030.
In other words, investors may want a little less Peking duck and a little more dressing. But finding funds light on China isn’t easy. Those with the lowest China stakes are typically focused on small companies or value stocks. Among diversified emerging market funds, the median allocation to China is almost 27%, with another 3% in Hong Kong — some are as high as 38% in Greater China, according to Morningstar.
The index is also concentrated on the stock level; internet giants Alibaba Group Holding (ticker: BABA) and Tencent Holdings (700.Hong Kong) make up more than 10% of its weighting, if South Africa’s Naspers (NPN.South Africa), which owns a hefty stake in Tencent, is included. Taiwan Semiconductor Manufacturing (TSM) and Samsung Electronics (005930.Korea) account for another 7.4%, giving this foursome an higher concentration than Microsoft, Apple, Amazon.com, Google, and Facebook have in the S&P 500 index.
Some managers are diversifying. “The trade war, in addition to the increased representation of China, has created an emerging markets index that is more sensitive to China,” says Howard Schwab, co-manager of the Driehaus Emerging Markets Growth fund (DREGX). “We are more diversified, finding more opportunities in areas that traditionally wouldn’t have been our sweet spot, like in Russia or in Eastern Europe.” While Schwab’s fund holds 28% in China and Hong Kong, he has been adding to Chinese A-share companies less correlated to the trade war.
Now, conditions are hardly perfect for a broad rebound in emerging markets. One big reason: Emerging markets tend to perform best when the global economy is emerging out of a recession, not skirting one, wrote Nicholas Colas, co-founder of DataTrek Research, in a recent note to clients. But it’s worth paying attention. After a decade of lagging behind the U.S., emerging markets stocks are relatively cheap, trading at 12 times forward earnings, compared with 13.5 for MSCI Europe and 17 times for the S&P 500.
Though cheap, the asset class still needs a catalyst. The Federal Reserve’s interest-rate cuts help, easing the pressure on countries with big current-account deficits. A U.S.-China trade deal or a strong recovery in China’s economy would also spark a broader rally, but money managers are skeptical that any near-term deal will resolve the longer-term conflict, especially as taking a tougher stance against China is one of the few initiatives in Washington with bipartisan support. Few see a sharp economic recovery ahead for China.
“I’m underweight China and overweight everything else,” says Laura Geritz, a long-time emerging markets manager who runs the Rondure New World fund (RNWOX), which returned 8.6% in the past year, beating the 94% of its peers. “I’m much more broadly diversified. It’s risky business in the whole world right now.”
That cautiousness has led Geritz to consumer-staples companies, including Asian Paints (APNT.India) and Nestlé India (NEST.India), that benefit if consumers recover, but also have more cash than debt, which would help them weather a continued economic malaise. Geritz also has hefty stakes in smaller markets, such as the Philippines and Vietnam, viewing them as great diversifiers in a world where “global synchronized growth is reversing into a world where we seem to have durable synchronized slowing.”
Vietnam — classified as a frontier, rather than emerging, market — benefits from companies moving production to tap cheaper labor and hedge bets in the trade war. The Philippines benefits from a large pool of English-speaking workers.
Seafarer Overseas Growth and Income fund (SIGIX) manager Andrew Foster is worried about China. “The economy is weaker than people think,” he says. “The trade picture for China will remain fraught and put further pressure on China’s already slowing economy.” Foster’s allocation to China is about the same as the index’s, but his top holdings differ: Alibaba and Tencent don’t crack his top 10, but two domestic Chinese companies do — Utility China Yangtze Power (600900.China) and China International Travel Service (601888.China). He also has a heavier weighting than the benchmark in Hungary and Korea, where valuations are cheap and new shareholder activism is improving corporate governance.
Slowing growth has brought a reassessment of the long-term case for investing in emerging markets. It used to be based on the idea that economic expansion would be rapid as countries became richer. But that narrative was faulty, wrote Justin Leverenz, manager of the Invesco Oppenheimer Developing Markets fund (ODMAX), in a recent blog post. The high-single digit growth of emerging markets was driven primarily by China, India, Indonesia, the Philippines, and Pakistan — and much of it was a product of globalization and China’s rise. Few see a repeat.
Veteran managers are looking for globally dominant companies that can do well, regardless of the economic backdrop. Leverenz likes Tata Consultancy Services (TCS.India), Taiwan Semiconductor, and Russian gas company Novatek (NVTK.Russia). Also favored: companies that are taking market share or becoming more efficient. Driehaus’ Schwab has found opportunities in Russia, which is seeing a renewed emphasis on more judicious capital allocation — a shift that could reduce the market’s sensitivity to oil swings, Schwab says. The dividend yield in Russia has risen to more than 7% from 2.5% in 2011, and the Russian stock market is up 15% this year, despite the volatility in oil prices.
The managers at the Virtus Vontobel Emerging Markets Opportunities fund (HEMZX) are also underweight China, in part because they’re finding better opportunities elsewhere. “Southeast Asia is suffering meaningfully from the negative impact of the trade uncertainties in the short term, but they are positioned well for the longer term, as trade gets redirected into the region and investments are made,” says Jin Zhang, the fund’s co-manager.
In addition, strong franchise businesses are trading at attractive valuations, while high-quality Chinese companies are largely pricey. Two such holdings: United Overseas Bank (UOB.Singapore), which is based in Singapore but generates 40% of its business abroad, including in Malaysia and Indonesia, and Telekom Indonesia (TLKM.Indonesia), whose margins are improving. Both pay dividends; the bank yields 5%; Telekom Indonesia, 4%.
Write to Reshma Kapadia at email@example.com
(END) Dow Jones Newswires
October 08, 2019 18:31 ET (22:31 GMT)
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