Graham O'Neill's Emerging Markets Update

08 Jan 2024

Graham O'Neill's Emerging Markets Update

China: manufacturing & property

In contrast to the United States where growth has surprised on the upside, China has been the major economic disappointment of 2023. After initial euphoria over the unexpected dramatic post-pandemic reopening, China initially did see a pickup in the service sector but focused on smaller ticket spending such as dining out and entertainment. The manufacturing sector in China suffered from what Jay Powell referred to in his recent press conference as people having too much ‘stuff’ and being unable to store any more goods creating a scenario where manufacturing exporters across the world have experienced sluggishness in demand as spending switched to services. 

The consumer in China left the pandemic in a vastly different position to the West. China did very little in terms of consumer support during the Covid-19 period. Hong Kong gave its residents spending vouchers, but Chinese consumers received nothing. During the many periods of lockdown, people were forced to draw into their savings and in contrast to the developed world, Chinese consumers did not build up a buffer of excess savings during the pandemic. In the West, the stock markets had been buoyant, so when lockdown measures eased there was a positive wealth effect with property values rising. 

In China around 80-90% of savings are held in property but with a difference when compared to the West as many of these are unfinished apartments with a focus on ‘buy not-to-let’ rather than ‘buy to-let’. Historically in China, values of second-hand homes have been lower than new builds as they are considered ‘dirty’ once people have lived in them. Chinese investors bought these with the hope of capital gains in mind, but with property prices declining, this is no longer the case. The worst overcapacity issues are in lower tier cities, and it seems that in China, as in the developed world, excess inventory always occurs in the places people least want to live. In China, this is in no small part due to the less strong employment opportunities in lower tier cities creating a negative wealth effect with the service sector not seeing a strong rebound, especially in terms of employment. 


China: education and unemployment

China continues to deliver an increasing number of students into the labour market, and they do not want to work in menial manufacturing jobs. As these graduates are the output of the ‘One Child Policy’, they can live at home with doting parents who are happy to support them in a minimalist lifestyle while they carry out household chores. This, however, has had a knock-on effect on the spending power of China’s middle class, which is evident with the lack of overseas tourism. China has deliberately, some would argue, made it difficult for its citizens to travel abroad, perhaps preferring spending to be focused within the domestic economy rather than on luxury goods in Paris. There are delays both with renewing passports and getting visas and there is still a lack of international flights and those which are flying have much higher air fares. Pre-pandemic Japan was a popular home for Chinese tourists and while overall tourism levels in Japan have recovered, the numbers arriving from China remain low. 

China’s students once attended postgraduate school in droves. Now the value of post graduate education has been diminished by an overcrowded jobs market, so many students are deciding not to pursue further studies. The private sector, especially on the Internet and IT related space, has suffered from the regulatory crackdown which, although now being eased, has not yet seen an upsurge in job opportunities. Students in China now view the civil service with its relative security and stability as a viable alternative to further education or working in the private sector. A record 2.25 million people sat the national public servants’ exam in November, vying for 39,600 vacancies at central government agencies which is a rough recruitment ratio of one out of every 57 applicants. These positions are still widely regarded as ‘iron rice bowls’ with near guaranteed tenure and benefits, despite relatively low pay. 

The authorities in China need to take measures to revitalise the private employment sector which has been the driver of jobs growth over the past decade, especially in IT related sectors. China continues to have record youth unemployment which, when it topped 21% in July, was no longer reported by the authorities. However, there are stories that leading universities such as Peking University has an unemployment rate of graduates in excess of 40%.


China: policy making and valuations

The previous administration under Hu/Wen had a consensus decision making process among the 9-member Politburo Standing Committee, but today’s smaller 7-person Standing Committee is very much driven by the policies of one person, Xi, which at present are not focused on domestic consumption. Policy making has also become more erratic and difficult to predict, as was demonstrated again with the gaming crackdown unexpectedly announced on December 22nd. China’s state health insurance system has lost tens of millions of scribers as rising premiums drive cash-strapped families to cancel coverage. In the short term in China, the target of ‘common prosperity’ has turned into ‘common austerity’ and with no signs of support for the property market, consumption is likely to remain under pressure. Valuations in China equities look cheap by historic standards and even allowing for the fact that with geopolitical tensions, market ratings will not return to historic levels, they have the potential to offer value to longer-term investors once the current earnings downgrade cycle comes to an end. For investors in China, there is a necessity today to be patient, but to also recognise policy can alter immediately as was seen with the end of the Covid-19 lockdowns. 

The property sector does not place a systemic risk to the economy in China as struggling private developers are being taken over by the State, and State-owned banks, with non-performing loans, will continue to be supported. Private buyers of homes who are waiting to move in have seen the State take over failed developers and so they do receive their properties, albeit with a delay. In the short term, the move to premiumisation by the Chinese consumer is on hold and will need a shift in policy to reverse this. The Chinese Communist Party has always relied on its ‘Faustian bargain’ of offering its citizens rising living standards in return for a lack of political freedoms, so the government will be aware of the risk of social unrest. 

Chinese consumption was very strong in the post-GFC period; the simple dynamic that the minimum wage in the decade post the Financial Crisis rose by 8-10% a year, considerably ahead of inflation, in contrast to what occurred in the developed world, goes a long way to explaining the increases seen in consumption levels in China in this period with the trend to premiumisation or upgrading of products benefitting many businesses. In contrast today, China is seeing wage cuts, and even some local authorities are reported to have cut wages by 30%. Many tech companies have not only shed staff but also reduced wages. China has increased GDP per capita from less than $1,000 in 2000 to around $13,000 in 2022 but remains well behind the US number of $76,000. To avoid the middle-income trap in which a country’s progress plateaus before it gets rich, China needs to put in place policies boosting domestic demand. 


India’s investment story

India has gone from strength to strength in 2023 and the country’s macro and corporate fundamentals remain positive. Amidst sluggish global growth, the Indian economy has grown in the range of 7-8% with softening crude oil prices a positive for the economy. Overall, corporate results have been positive in India, although the banks have seen some concerns that net interest margins may be peaking in the short term as the global interest rate cycle tops out. The private sector banks continue to gain market share and the under penetration of the banking sector, mortgages, and consumer credit at an overall country level suggests they remain a strong long-term investment story. India has also continued to benefit from the development of the shift in manufacturing away from China with government policies attracting inward investment to the manufacturing sector. The valuation of some stocks looks stretched in the short-term, but there are still pockets of opportunity within the Indian market. Due to the higher quality of companies listed and political stability (Modi is widely expected to be re-elected for a third term in 2024), India is always likely to trade at a premium rating compared to the rest of Asia. 


Asean economies

Among the Asean economies, Indonesia has benefitted from the policies of President Jokowi and the election in 2024 is expected to hand power to his preferred successor. Indonesia has benefitted from moving away from being a low added value exporter of commodities such as pure ore-based products, to carrying out some of the added value extraction within the country and there remains a young low-cost labour force which should see an increasing share of global manufacturing. Other Asean countries continue to see sluggish growth and in Thailand, tourism has been slow to regain previous levels with an absence of Chinese visitors. 


Structural trends in North Asia

Other North Asian economies, such as South Korea and Taiwan, should benefit from a bottoming out in the semiconductor cycle and the high value add semiconductor industry in Taiwan is benefitting from the structural trends towards automation, digitisation and AI. 


Activity in Latin America

Leftist President Lula has sparked some concern among investors, but his lack of control of Congress has meant that policies to date have not been extreme and with the Brazilian central bank tightening rates early, inflation appears under control with the prospect of rate cuts in 2024, which would be supportive of the stock market. Brazil is likely to see GDP growth in 2023 of around 2.5-3.0%. Mexico is benefitting from the reshoring or nearshoring of global supply chains away from China and the expansion of activity by Chinese manufacturing companies in that country. The currency has benefitted from interest rates of more than double that of the US and growth this year should come in above 3%. Economic policy has been hit and miss under president Amlo, but the long-term fundamentals of the country remain strong, and the market continues to offer potential for investors as long as it focusses on the policies needed to continue to win reshoring business. 


Emerging market summary

External factors will also be important for emerging markets, although at present the China administration has sought to diffuse international tensions as it comes to grips with a domestic economic slowdown. The China/Taiwan issue has not gone away. In a televised speech on December 31, President Xi said that the reunification of Taiwan and China was a ‘historical inevitability.’ Taiwan holds its presidential elections on January 13 and the current frontrunner Lai Ching-te of the ruling Democratic Progressive party has been denounced by Beijing as a separatist.

If elected, Trump is likely to impose additional tariffs on all imported goods into the US, although China has seen improved competitiveness in manufacturing exports because of lower wages and a depreciated currency. There is the threat of more China targeted policies with aggressive new restrictions on imports of certain categories of Chinese goods, as well as stopping American businesses from investing in China unless in the interests of the US. A second Trump presidency runs the risk of an escalation of already present trade tensions into a vastly worsened trade war. These risks need to be considered when assessing the outlook for the emerging market region, against which are generally favourable valuations, and for many countries an improving or positive fundamental economic background.

Overall, emerging markets in 2023 suffered some valuation pressure from the rises in US interest rates, bond yields and the US$ which should go into reverse in 2024. Inflationary pressures in most emerging economies are more in line with historic averages than in the developed world. Neither is there the shortages of skilled workers prevalent in some developed economies. Many countries have attractive demographics and are benefitting from multinationals pursuing a China Plus One policy in terms of how they achieve manufacturing diversification. Valuations in emerging markets by historic standards look attractive so the region does offer value for longer term investors, although at the index level China accounts for around a quarter of the benchmark and this has depressed returns in 2023 at the Index level. 

Graham O’Neill, Senior Investment Consultant, RSMR


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