China is creating a divide in emerging markets and some countries are in danger of getting left behind, according to Hermes Investment Management’s Gary Greenberg.
The manager of the £3bn five FE Crown-rated Hermes Global Emerging Markets fund said that, traditionally, emerging markets have followed the western model of raising standards of living, getting richer and a rising middle class.
But this is no longer the case and a divide is being created in the emerging markets between those that continue to do this and are performing well, and countries that aren’t following this blueprint which are in a lot of trouble.
One of the main contributors to this split is China, the country that makes up nearly 31 per cent of the MSCI Emerging Markets index.
When China joined the World Trade Organisation at the turn of the millennium, it started a period of tremendous growth in exports from the Asian powerhouse.
FE Alpha Manager Greenberg said these exports were rechannelled into infrastructure in China and it built a “first-class, first-world infrastructure”.
“That was very good news for commodity exporters like Brazil, South Africa, Argentina and Russia because commodity prices have taken off over the last decade and a half,” he said.
Performance of fund vs sector and benchmark
Source: FE Analytics
“But now, partly because of the demographics - an ageing workforce around the world buying less stuff - and also because of protectionism and because China used debt to fuel its dramatic growth, China is no longer going to be the source of demand for commodities.
“The government itself has changed emphasis dramatically from a debt-fuelled infrastructure boom towards a consumption-led higher-value added, higher quality of living-type economic model,” he added.
While this is a change of gear for the country, the Chinese government is not the first smart policy makers to do so.
Japan did it first by investing in low-labour cost industries and working their way up, then the Asian tigers – Hong Kong, Taiwan, Singapore and Korea – followed suit and now China has done it.
Japan, Hong Kong, Singapore (and Korea if you use the FTSE Emerging Markets benchmark) have now all been promoted to developed market status.
Greenberg said: “China’s now graduating into higher value-added things like [artificial intelligence] AI, social networks, electric cars, they’ve got a quantum computer or two in the country et cetera.
“And then eventually, making their own chips and starting to move lower value-added manufacturing to places like Vietnam, Bangladesh, Laos, Cambodia.”
And it was all going OK, according to Greenberg, until US President Donald Trump came along with his protectionist-driven trade war rhetoric in an attempt to stop China’s growth dead in its tracks.
He said that China is now in a delicate position where it is trying to transition away from the old model and not use a lot more leverage but at the same time its economic growth is slowing from these efforts to reduce debt.
Aside from China’s personal problems, their desire to follow the Asian tigers and change their economic model has meant that the outlook for commodities is a lot weaker than it has been for the past 15 years, according to Greenberg.
China GDP annual growth rate over 5yrs (%)
Source: Trading Economics, National Bureau of Statistics of China
The emerging market that is closest to being able to fill China’s boots is India, which has a huge population but its economy is a lot smaller than that of China.
“India doesn’t have the kind of command economy which will result in the kind of recycling of surpluses to infrastructure, although it is working on infrastructure,” said the manager.
“But it’s not big enough and the demand isn’t big enough to replace China.”
Therefore, many of the wider emerging markets economies will be hit by China’s transition away from commodities.
“This has implications for Venezuela and Colombia (both oil economies), for Russia which is oil and nickel, also for Brazil which is iron ore and to some extent nickel, South Africa which is coal and various base and precious metals, Australia, Indonesia et cetera,” said Greenberg.
“So, for all these commodity exporters, life’s tougher because China’s not going to be the locomotive of growth and India’s not going to make up for it most likely.”
He said that if we characterise emerging markets by the ‘old way’, which is cyclical economies that export commodities and have a comparative advantage of geography and low-cost labour, then “they don’t have much of a future”.
“So, the way I would look at it is I would divide emerging markets into successful contenders and countries that are going to be less likely to be successful,” said Greenberg.
And the emerging markets benchmark has changed a lot because of this transformation.
The countries that used to be the bigger economies in the benchmark – Brazil, Argentina (which is now a frontier market), Russia, South Africa and Malaysia, which Greenberg said used to represent 26 per cent of the benchmark in 1993 – have now all shrunk because of the shift away from commodities.
Country weightings of MSCI Emerging Markets benchmark
Source: MSCI Emerging Markets
The size of the different sectors within index has also changed: “About 10 years ago the materials and energy sector contributed about 29 per cent of the benchmark and now they constitute only about 13 per cent, overtaken by information technology, consumer discretionary et cetera,” he said.
“So, what we’ve got actually is a benchmark that reflects the better quality of business model, or country model which has been pursued by switched-on country management.”
Based on his above beliefs about the emerging markets dividing, Greenberg said that investors shouldn’t be surprised about the allocations he has to different regions in his fund.
He is overweight in China, Taiwan, Hong Kong and India and is underweight in South Africa while being neutral in Brazil and Russia.
On a sector basis, Greenberg is overweight information technology, financials, consumer discretionary and healthcare and is underweight, materials, energy and telecommunication services.
Hermes Global Emerging Markets has a clean ongoing charges figure (OCF) of 1.13 per cent.