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Written by: Regina Chi, CFA® | AGF
When China finally (and suddenly) abandoned its draconian Zero-COVID policy last November, investors understandably expected the world’s second largest economy to come roaring back. Buoyed by optimism over the lockdowns and quarantines finally ending, the MSCI China Index over the following three months soared by 60% from its pandemic-era lows, according to Bloomberg data. Since then, however, the boom has fizzled. Second-quarter GDP growth disappointed, putting China at risk of missing its own already modest 5% target for 2023. China stocks, meanwhile, fell flat, with MSCI China ending July up only 4.7% on the year.
China turned in that humdrum performance even while other Emerging Markets (EM) largely surpassed expectations in the face of high inflation and tighter global monetary conditions. The MSCI Emerging Market Index (which includes China) gained 11.4% to the end of July. Take China out of the mix and the results are even more impressive: MSCI EM Ex-China returned 14.6%.
Could an EM ex-China strategy continue to produce such asymmetrical returns going forward? We believe its possible, at least in the short to medium term.
As China reopened last year, investors may have underestimated the deep scarring left by Zero COVID. Even months later, the pandemic hardships remain fresh in people’s memories. Practically overnight, the virus they had been told was lethal – so deadly that they had to stay at home for weeks to save their lives – was transformed (in Beijing’s edicts, at least) into a bug little more worrisome than the cold or the flu.
But the legacy of three years of harsh pandemic control is not so easily erased by government newspeak. Data published by China’s National Bureau of Statistics in mid-July show that GDP rose by only 0.8% quarter-over-quarter in the second quarter down from 2.2% for the first three months of the year.
The expected uptick in domestic consumption has not materialized post-pandemic. Chinese consumers may be cash-rich, but they don’t have the confidence to spend it. Retail sales have missed market expectations, slowing to 3.1% growth year-over-year in June from 12.7% in May, according to Bloomberg. Inflation turned negative in July, with the Consumer Price Index (CPI) declining by 0.3%, raising concerns of a deflationary spiral.
Meanwhile, consumers’ decades-long belief in real estate as a reliable store of wealth is under assault. Property is a huge part of China’s economy, comprising more than two-thirds of household assets and 25%-30% of GDP, according to the Peterson Institute for International Economics. But the sector is weak: investment declined by 7.9% year-over-year in the first half. Where is the cash going? Safe harbours like deposits, which have grown by 30% since 2019, according to Morgan Stanley.
The corporate sector also lacks confidence, not just because of the COVID policy hangover, but also because of the regulatory crackdowns on the private sector in recent years. In July, the producer price index fell by 4.4.% – the 10th straight month of decline in prices paid for goods and services
There is some potential good news. China’s authorities have been making all the right noises about supporting the private sector, suggesting that stimulus for small and medium-sized enterprises (SMEs) and consumers is imminent. Even with worrying signs on the horizon, GDP growth will still likely outpace the United States or other developed countries. Given that the MSCI China Index is down (by 5.1% in the first half), investors might consider Chinese equities a long-term buying opportunity.
China’s road to recovery, however, is anything but certain. Even if government stimulus is coming, it will take time to have a meaningful impact. The state of consumer and business confidence remains a wild card. Tensions with the U.S. will likely continue to be a drag on growth, meanwhile, as we believe the Biden administration’s recent ban on U.S. investments in some advanced Chinese industries suggests.
As the China story plays out – and who knows how long that will take – investors might look to other Emerging Markets for returns in the short and medium term. Chief among them are Taiwan and South Korea, which have benefited from the same artificial intelligence (AI) frenzy that has seized U.S. markets. Both tech-heavy indexes, MSCI Taiwan and MSCI Korea were up by 19.1% and 15.8%, respectively, in USD terms in the first half of 2023 (per Bloomberg).
Developing European economies are often overlooked in the EM mix, but we believe they should not be, given their recent performance. That’s especially true for Central Eastern European markets like Poland and Hungary. One might think that double-digit European inflation and the region’s proximity to the Ukraine War would have plunged it into a deep recession. Instead, Polish and Hungarian equities have performed extraordinarily well, up 23% and 28%, respectively, in the first half, boosted by falling inflation, interest rates and energy prices, as well as relatively cheap valuations.
Greece, meanwhile, looks like one of the most sustainable structural growth stories in Emerging Markets, with both macroeconomic and earnings numbers very positive. Following the election of a pro-business government in June, Greek equities finished the first half of this year up 44%.
Finally, Mexico is one of the best-performing EM equity markets so far in 2023, up 32.9% on the year to the end of July. Part of the reason is peso appreciation, but that doesn’t tell the whole story. Earnings growth is robust and political risk has dissipated, while global investors are positioning for the upside from nearshoring that Mexican stocks could realize.
China’s disappointing “rebound” has been a drag on overall Emerging Market returns this year – hardly surprising, since Chinese companies comprise about half of the MSCI EM Index. But there is no law that says investors must include China in their EM exposures. So far this year, EM ex-China has delivered much more robust returns, and we see no reason why this should not continue for some time.
Of course, many EM investors still see substantial upside in the world’s soon-to-be-largest economy over the long term. We do, too. But given the strong performance and potential of other Emerging Markets right now, why wait for China to finally turn things around?