We need to talk about the ex – is EM as an asset class ready to separate from China?

In the latest episode of the Emerging Markets Equities podcast, Nick is joined by Hasnain Malik from Tellimer to evaluate emerging markets as an asset class. Discussing China and US relations, manufacturing diversification and the commodity cycle. 

Transcript

Nick: Hello, everybody, this is Nick Robinson from abrdn and you're listening to the Emerging Markets Equity podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions from key individuals to evolving trends, all with a goal to identify and profit from opportunities in the region. So, today's conversation I've been looking forward to for a while, I'm really delighted to be joined by Hasnain Malik, who is the head of emerging markets and frontier market equity strategy at Tellimer. So, for those that aren't familiar with Tellimer, it's a research firm that really specialises in emerging and frontier markets. Hasnain is a leading expert on emerging markets and frontier markets and he has over 25 years of experience in EM, having started his career at Citigroup in the late 90s. In today's conversation, we're going to have a broad discussion of how he thinks about emerging markets as an asset class, some of the key themes in EM investing at the moment, and opportunities that Hasnain sees going forward. So Hasnain welcome to the podcast, how are you? 

Hasnain: I’m well, thanks, Nick, how are you? 

Nick: I'm very well, thanks. It's a real pleasure to have you on. So, let's start on emerging markets broadly, as an investment opportunity. Yeah, when I think about our portfolios, it's a pretty diverse range of countries and companies, and we have investments in some of the highest tech companies on the planet in Taiwan. And then at the other end of the spectrum, we have, for instance, companies that just sell cement in Peru. So, given that broad range and everything that's in between, how do you think about emerging markets and frontier markets as an asset class, and how to really make the most of the investment opportunity set that it presents? 

Hasnain: Well, I think you summed it up, and that it is a very very heterogeneous asset class, you know, if you just look at the range of countries, and we're talking about almost 50 plus countries in this universe, you have wide spectrum of economic size, equity market liquidity, you know, you think of, say, a behemoth like China at one end, and then an absolute minnow like Georgia, or Zimbabwe at another, you've got very different range of fundamental characteristics, you know, you've got some countries with very strong balance sheets like Taiwan, Korea, Saudi and the rest of the GCC. And then you've got some really fragile countries in terms of external debt and vulnerability, like Egypt or Pakistan or Kenya, you've got, you know, a range of political systems, you've got some really stable governments, whether they're democratic or authoritarian. So, you had the likes of, let's say, India, or Saudi Arabia at one end, who have got the capacity for reform. And then you've got those, again, who are very volatile in political terms can't take long-term decisions, and really kind of are always running short-term kind of tactical management. And then if you look at things geopolitically, you've got some countries who are still very closely aligned with the United States, rely a great deal on the amount of trade and investment they interact with the US and of course, US defense cover. And then you've got a growing number of countries who are effectively looking to hedge their geopolitical bets a little bit. So when you kind of take a step back, and you look at that very varied universe, in my view, what that screams out is that you have to adopt an active portfolio approach, you've got to be actively choosing which countries you're selecting which sectors which stocks, and you have to be nimble, because I think particularly in a year like this, there is no single theme that is going to dominate and lead equity markets globally. I think at different times, you're going to have to gravitate towards those countries with strong sovereign balance sheets at different times you have to embrace again, where is there structural growth available in the tech sector as you mentioned earlier. When is it the time to be heavily invested in commodities. When is it time to look at manufacturing opportunities and tourism opportunities. And I think your only discipline, looking at all those different themes is obviously be very conscious of valuation, you've always got a screen for valuation. My preferred metric is generally valuation relative to a markets own history, but I think those are the themes that you need to have all of those bows in your quiver as, as it were. 

Nick: Yeah, thanks. I mean, that's something certainly I think we'd agree with at abrdn. You mentioned China, in your initial comments and just the size of that market, and I suppose given how it is the largest market in the emerging market benchmark by some margin, despite all the challenges it's facing at the moment. Yeah, how do you see China shaping up? Both in terms of the local economy there, but also the more existential issue over their relations with the rest of the world? And particularly the US at the moment? 

Hasnain: Yeah, I mean, as you say, it's still a very big chunk of the benchmark indices, you know, around 30%. So, it can't be ignored. And if you think China's uninvestable, then as the benchmarks are currently constructed, you're going to have a big problem with looking at emerging markets overall. I'm not in that camp, I don't think it's an uninvestable, I do acknowledge that the old model of you know, tons of investment in infrastructure, and property domestically, and a drive to grow manufacturing exports in a world of relatively free trade from a Chinese perspective. That old model has lost steam. So, there is definitely a deceleration of growth underway. And I think equity market valuation in China reflects that pretty fully. I think what the market is maybe a little bit too greedy for and is going to be disappointed by is this hope that China is going to respond to this challenge the way that maybe the US might have done post global financial crisis or post COVID, which is with kind of some kind of bazooka level stimulus. I don't think that's coming in China, because there is already an excess of infrastructure. So, the marginal returns from just piling on more infrastructure is pretty low. I think also, the authorities are very sensitive about reinflating a real estate bubble they've been trying to deflate for a number of years. And I think also remember with you know, total government debt to GDP, so when you throw in local government debt as well, that statistic up around 100% it's not as if the Chinese government can simply put cash into the hands of Chinese consumers and say, right, go forth and spend in the way that maybe a country with the sort of exceptional advantages on monetary and fiscal policy like the US has, so it's definitely a tougher time domestically. But as I say, there is a price for everything. And I would say that's largely reflected in Chinese valuations. When it comes to the second part of your question, which is around US relations. Yep. I'm not sure those are going to get systematically better anytime soon. I mean, you could argue that the one issue on which there is bipartisan agreement in the US Congress is on the suspicion of China and the threat perceived from China. So, there's certainly been no softening of the anti-China stance and the transition from President Trump to President Biden. There's no change in US Congressional views. And I would argue on most fronts, China has kind of been losing out in that friction, whether it's access to cutting edge technology, whether it's the geopolitical alignment we've seen much more tightly now between the US, Japan and Korea, the US and the Philippines, the US and Vietnam, the US and Australia, and in a more tentative way, the US and India, but to take all of that whether it's the domestic challenges, the foreign policy challenges, I don't believe that Xi Jinping, Communist Party General Secretary and effectively ruler for the rest of his life is irrational. I don't see his default response being just keep doing the same things that are not working out on domestic economic policy, or go forth and, you know, do something really disruptive like invade Taiwan. I don't see that happening. I think the history of Xi Jinping is a much more pragmatic one than that. And that's why I would say that that sort of view that China is somehow uninvestable, that's not one that that I subscribe to. Difficult, yes, but priced in not uninvestable.

Nick: So you see, I suppose these current geopolitical tensions as being more transitory in a way and you think that it's, it's possible that the relations are going to improve going forward? Would that be, would that be fair? 

Hasnain: No, I wouldn't go that far. I don't see this as a transitory sort of fractious environment, I think that will continue. But there are limits to it. You know, this is not cold war 2.0 because of the economic interlinkage of the US and China. And yes, there are plans, and there are efforts for diversification of supply chains and things like that. But it is still very hard for the world to find another factory as big as the one that China effectively has. So, I don't see a complete disconnect. I just think that the capacity of that of those fractious relations to surprise investors, I think that has dissipated. I think everyone now understands that this is going to be a difficult environment in terms of international relations. 

Nick: I suppose one thing that we've been seeing, particularly with some of our clients in the US, but actually not just in the US it started to occur more in Europe is the keenness to start limiting the magnitude of investments within China, such for emerging markets ex-China is becoming I suppose an asset class, that institutions seem to be having a bit more Interest in. Do you think that's a that's a trend that's likely to continue. So, the separation of China out from emerging markets?

Hasnain: Well, I would have some sympathy with that move. And I've certainly heard that sort of talk as well. But it actually predates China's slowdown in economic growth or the disappointment around recovery this year, or concerns over how bad relations with the US gets, it really started when you got to a point where China at peak was almost 40 plus percent of the benchmark index. And that completely skews the asset class, it really means that in a sense, there's not much point in worrying about much else apart from China. And if you were to do that, you know, that would orphan effectively four or five other very big emerging markets, India, Brazil, Taiwan, Korea, and others. And it would completely make irrelevant, you know, a long list of about fourty, other four zero other emerging market and frontier countries in which there is a lot of opportunity either, in terms of high growth, capital market, development, transformational change. So, I think that move was underway, regardless of the merits or demerits of the China investment case, specifically, just because it was so big and outsized relative to the rest of the universe. And I do think it makes sense, it makes sense if you can create an asset class that allows you to take much bigger proportionate exposure to markets like India and others are, for example, in the GCC and smaller down the universe, to get exposure to those themes like tourism, manufacturing, commodities, technology driven transformational change, structural reform, all that good stuff. Having a universe that's ex-China allows you to do that, because it actually makes those smaller markets more relevant to a new benchmark index. So, I certainly have sympathy with that. 

Nick: Thanks. Yeah, I mean, that certainly feels like the way the world is going particularly I read some research recently that suggested that China's weighting within the benchmark could be as much as 50% at some stage with a shares being weighted more reflecting their market cap. Yeah, I suppose thinking a little bit outside of China, particularly some of those countries that benefit from supply chain diversification away from China, like Mexico and Vietnam. I mean, how would you see those as investment opportunities today and any other countries you'd highlight as a beneficiary of that trend?

Hasnain: Yeah, so the first thing I would say is yes, there is without question a drive post COVID for supply chain diversification. And that's being accelerated by, as I say, the sort of friction we've talked about between the US and China. And the question is, you know, what do you need as a multinational for a China plus strategy for manufacturing. Well, you know, I'd say you need low wages, you need a large labour force, you need a place that enjoys low tariff access to both the EU and the US. And you need broadly, some sort of relative political stability doesn't have to be perfect, but relatively politically stable. And you don't need the ideals of perfect logistics, you don't need, you know, necessarily very advanced educational attainment, but you need at least you know, a subset of the factors I’ve mentioned. And yeah, you're absolutely right, that the two most glaring beneficiaries are Mexico, which not just benefits from supply chain diversification, but also nearshoring and Vietnam, which has far and away the cheapest labour in Asia, allied with the lowest tariffs access to both the EU and the US and is demonstrably growing its net manufacturing exports. But there are others, you know, in large emerging markets, obviously, there's India, in the smaller emerging markets, if you go through it by region, in Asia, you don't just have Vietnam, but you also have at the cheaper wage end the likes of Bangladesh, and the Philippines. In Latam, it's not just Mexico, you also have Colombia, although obviously with a smaller labour force. And even in Africa, you already have demonstrably Morocco, benefiting from these sort of trends. And if we could just get its act together in terms of macroeconomic policy management, you would have Egypt as well. So, there are certainly a number of different players that give you access to that kind of China plus manufacturing thing. 

Nick: And you mentioned a lot of frontier markets in that response. So, kind of interested in if you think there could be scope for frontier market resurgent at some point because that was an asset class that perhaps 10 years ago had an awful lot of positive news flow around it, which, which now appears to have gone off the radar to some extent?

Hasnain: Yeah, I mean, I think if you look at valuation opportunity, frontier markets are generally cheaper than the large emerging markets. I think if you look at, again, the heterogeneity, the diversity of those frontier markets, some of them no doubt have fragility, at the moment, they are suffering in an environment of relatively high US interest rates or low-risk appetite, and high commodity prices, particularly in oil, but not all of them. So yes, for every Pakistan, there is a Kazakhstan. For every Kenya, there is a Morocco. So, there is balance in that in that universe. The challenges and as it was 10 years ago, is obviously the level of liquidity in those equity markets is a great deal lower than in emerging markets. So, the size of assets that can be deployed in frontier equity is necessarily so much less than can be deployed in large scale, or even mid-sized emerging markets. But is there an opportunity for anyone who has the luxury of patience for true kind of country transformation at that frontier end, absolutely.

Nick: Yeah, certainly thinking as a bottom-up investor, we have a handful of frontier market investments in our funds, and some of them are probably the most exciting businesses that we invest in, given the opportunity set they have. If we take a step back, I mean, thinking about the asset class, historically, it tends to do quite well when the dollar weakens, and commodities strengthen, particularly those regions like Latam, that are big commodity exporters. So, talking today in late September, with oil getting close to triple figures, again, do you think we could be setting up for a similar post-global financial crisis commodity boom? And putting into perspective, I suppose one of the key differences this time around versus 2009 is the emergence of the Middle East in terms of being a large part of the benchmark and a large contributor to the opportunity set. So, you know, perhaps talking about that would be interesting as well. 

Hasnain: Yeah, I mean, I think it's fair to say that without knowing the exact timing, you know, we are getting close to a peak in US inflation a peak in US rates. And barring any kind of global calamity that drives this rush towards safer assets, we should see some softening in the dollar. And that is normally a supportive environment for emerging market assets, and particularly commodity prices. And I think we have an interesting moment. And when I say moment, you know, a phase that could last multiple years where in the emerging markets, you can get exposure currently to really what will be the last surviving oil exporters, because some of the cheapest oil production is in the countries that you mentioned, particularly in the Middle East, at the same time, as you can get exposure to the key commodity that forms a part of the renewable energy transition, which is copper. So on the one hand, not only do you have this very juicy window in terms of export prices for the likes of Saudi Arabia, the rest of the GCC, like Kuwait, Qatar, the UAE, others in the emerging market universe, like Kazakhstan, Colombia, Nigeria, if you want to go right to the frontier end, you have that as an oil complex, at the same time, as you can get exposure to copper exports via Chile, Peru, and then again, at the very frontier end the likes of Zambia. So that's the part of commodities that could be very powerful. Now, you know, would I describe it sort of another post-global financial crisis type supercycle. Probably not because on the demand side, we don't have another build-out on the scale of China to occur over the next decade. So, it's not really going to be a demand lead cycle. It's more about the shortage of supply. Remember, we've gone through years of underinvestment in upstream exploration of oil, and on copper mining development, because of obviously COVID and difficult financial conditions over the last few years. So that's what I think creates in a softer US rate environment, such an interesting play in commodities for EM for emerging markets. You are absolutely right, that compared to a generation ago, the Middle East is so much more important than it was as an addressable accessible opportunity for foreign investors. And what I would add is what makes the Middle East in general, so much more interesting than Latin America is structural reform. You know, you could never have imagined ten years ago that in the last five years, we would see a social revolution in a place like Saudi Arabia. And how you demonstrate that is consider something like female labour participation. You could never have imagined that going from 20% at the start of 2017 to 50%, five zero by the end of 2022, at the same time, as female unemployment has dropped from 35% to 20% that is a social transformation which has happened in a compressed space of time, unlike I would argue we've seen anywhere else in the world before. That's your Saudi Arabia. If you look at elsewhere in the GCC, we're seeing liberalisation of long-term residency rules, which is making the expat communities much stickier. And again, if you look at an example of social liberalisation, consider the United Arab Emirates, which has now established a gambling, regulatory body, which shows you what the next phase of diversification is there. That is a set of examples of structural reform, which I really don't see in places like Brazil, Argentina, Colombia, Peru, Mexico, etc. 

Nick: Okay, thanks, Hasnain. That's interesting. Yeah, certainly as someone who's visited Saudi, reasonably frequently over the last ten years or so you can really see the change that's been underway in that country. And certainly, the investment opportunity set there has really improved in the last few years. Do you think you know, there's one trend that's been talked about a bit more in emerging markets and globally in the last couple of years is really this kind of desire for emerging markets, particularly places like Saudi and China to move away from the dollar in terms of how they settled transactions? Do you think this kind of dedollarization. perhaps it's not quite a trend. But dedollarization. theme is something that we should be paying attention to in emerging markets? 

Hasnain: Well, I think when we talk about the role of the dollar, we've got a segment two things. One is the use of the dollar as a method of settling transactions or trade. And yes, there are some tentative moves towards the adoption of bilateral currencies for that, I must say that the announcements are a lot more dramatic than the implementation has been thus far. There's another side of this debate, which I think is very badly misunderstood, which is the role of the dollar as the dominant global reserve currency. And it's really that role, which gives the US a degree of exceptional leeway when it comes to its policies, and which makes the rest of the world's economic systems still very dependent on what goes on with US rates and the rest of the world's investment climate very dependent on what goes on with the US dollar. And there is, in my view, no challenge, at least in our professional lifetimes to the dominant role of the dollar as the global reserve currency. It is, I think, very unlikely that you will see, for example, China, allow the sort of free convertibility capital account liberalisation that will allow the renminbi to rival the dollar, it is very unlikely that you will see other countries offer the sort of rule of law transparency that the US does. And even though the US is testing the limits of everyone's appetite to use its currency as a reserve, through things like sanctions, which we've seen on North Korea, Iran, and of course, most recently on Russia, it's still very hard to find an alternative that is at least as good. And so, I don't think the US role as a reserve currency US dollars role as a reserve currency is going to change. At the margin, its share of global trade may erode a little bit. The bottom line is that conditions that are set for global investment analysis, I don't think change as a result.

Nick: Okay, well, great. That feels like a good place to draw the podcast to a close. So, the only thing left for me to do is thank my guest Hasnain. Thank you so much for joining today. 

Hasnain: My pleasure. 

Nick: And thank you everyone who took the time to listen in. If you enjoy today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for the next episode and tune in.