Separating China from Emerging Markets: A long-term winning strategy

• China, constituting a quarter of the MSCI Emerging Markets Index, is a major detractor of returns for EM investors.

• China’s shift towards a state-controlled economy, the ongoing property crisis, and shifting geopolitics serve as structural challenges that would continue to impact long-term growth.

• As investments and supply chains shift away from China, major opportunities can be found in other EM economies with low production costs and abundant labour such as India, Latin America, and ASEAN.

• Heavyweights in EM ex China like Taiwan and South Korea are poised to benefit as the AI boom creates a surging demand for semiconductors.

• Using a fair PE multiple of 14X, we project an upside potential of 24% for the MSCI Emerging Markets ex China Index, and a corresponding target price of USD 71 for the iShares MSCI Emerging Markets ex China ETF (NASDAQ:EMXC).

The Year of the Dragon has started out as a bumpy ride for China, standing in stark contrast to the S&P 500 and Nikkei 225 indices which have hit all-time highs.

Furthermore, China is the largest emerging market (EM), making up a quarter of the MSCI Emerging Markets Index. This means that its poor performance has become a key detractor of returns for EM investors even when most other markets are holding up relatively better (Figure 1).

In this article, we reiterate why investors should exercise caution by limiting their exposure to China within portfolios, and highlight how the iShares MSCI Emerging Markets ex China ETF (NASDAQ:EMXC) gets the job done.

Figure 1: China is the main laggard in EM

Investing in China carries unique risk

Investing in EM inherently carries risks, but when it comes to China, the set of challenges are truly distinctive. Despite the recent technical rebound of Chinese equities, long-term structural issues persist.

China’s shift towards a state-controlled economy represents a major departure from decades of economic reforms that helped propel it to substantial growth. An illustrative case is the property sector, where state-owned developers have seized a larger share of the pie amidst the property crackdown.

Furthermore, the central government’s decision to discard one of the most closely monitored events on China’s economic and policy calendar – the premier’s post-parliament press conference – adds to the growing concerns. During last year’s press conference, Chinese Premier Li Qiang sought to reassure the private sector amidst a deterioration in business confidence following regulatory crackdowns.

For three decades, a period when China was opening up, the press conference provided a rare chance for the world to gain insights into the country’s high-level leadership. The discontinuation has been touted as a signal that China is turning increasingly inward-focused and becoming more opaque.

Meanwhile, the economy continues to grapple with the property crisis. Debt woes within the property sector have kept homebuyers away and pressured home sales, sending the financial health of developers into a downward spiral. In February, contracted sales for the top 100 developers fell at a record pace of 60% year-on-year (Figure 2). Additionally, China Vanke was recently hit by repayment concerns. Taken altogether, these indicators suggest that the property sector has yet to stabilise.

Figure 2: Contracted sales have hit a new low

Despite increased policy support, China is still working through a combination of half-completed projects and unsold homes. The burst of the property bubble marks a significant downturn for the sector, and a swift recovery is unlikely to occur.

Adding to these challenges are the shifting geopolitics, particularly in the backdrop of heightened tensions between the US and China. Foreign direct investment (FDI) into China plummeted to a three-decade low in 2023, an indication that geopolitical tensions are impacting the country’s investment climate (Figure 3). The US maintains a stringent approach in restricting China's access to AI and semiconductors, risking tit-for-tat measures from China on foreign companies.

Figure 3: China inbound FDI is at the lowest level since 1993

(Related article: The 7 points you should take away from China’s “ Two Sessions”)

Deglobalisation provides more opportunities for EM ex China

Pivoting investments and supply chains away from China means all that money needs to find new homes. Many investments are being redirected into other EM countries with low production costs and an abundant source of labour. Opportunities are present for EM ex China markets as the world deglobalises, with production and trade becoming less dependent on China.

A notable example is India, a beneficiary of the “China plus one” strategy, in particular “friendshoring”. Warming ties between the US and India has resulted in Apple shifting almost one-fifth of global iPhone production to India. Separately, the Indian government is supporting the manufacturing sector with a series of measures such as corporate tax cuts and “Make In India” incentives. This is anticipated to drive strong exports growth and FDI inflows.

US chip makers Micron and AMD have agreed to pour up to USD 825 million and USD 400 million into India respectively. Notably, Micron is building a new assembly and test facility, partially funded by the Indian government, that is set to produce the first locally made semiconductor chip by end 2024.

Meanwhile, Latin America is increasingly positioned as a “nearshoring” destination for North American and European companies due to its strategic geographical proximity and cheap labour. Besides, with one of the world’s largest lithium reserves, Mexico has emerged as a hot market for automakers like Volkswagen and Tesla, who are aiming to ramp up their electric vehicle (EV) production.

Lastly, ASEAN - a smaller region within EM ex China - is emerging as an increasingly crucial “China plus one” destination. Indonesia, for example, has enacted the omnibus law to lure foreign investment and create new jobs. Furthermore, with its rich nickel reserves, the country is positioned to become Southeast Asia’s hub for the EV supply chain.

AI boom will benefit EM ex China

EM ex China will also assume great importance in an increasingly digitalised world. Apart from India, the heavyweights in EM ex China include Taiwan and South Korea. The two economies, driven heavily by the semiconductor industry, collectively make up nearly half of the index (Figure 4).

Figure 4: Taiwan and South Korea are key markets in EM ex China

As artificial intelligence (AI) takes the world by storm, there will be increased need for accelerated computing capacity and in consequence, a surging demand for the most advanced chips. Broader trends, such as the increasing number of semiconductor applications and the rising silicon content in them, will also contribute to greater chip demand in the coming years. Moreover, it is possible that markets may still be underestimating the level of chip demand required to support the growth of AI as it continues to deliver a transformative impact on digital products and services.

These structural trends will have a substantial positive impact on economies that are reliant on chip exports, such as Taiwan and South Korea.

Taiwan, home to the world’s top chip foundry TSMC, is a pivotal player in the global semiconductor landscape. TSMC, a critical supplier of Nvidia’s AI processors, reported a 7.9% year-on-year increase in January sales, as strong demand for AI chips helped offset continued weakness in consumer electronics products. As chip demand grows, TSMC is expected to outpace its peers thanks to its lead in the most advanced technology and AI chips.

On the other hand, South Korea excels in the area of memory chips, led by industry giants Samsung Electronics and SK Hynix. Both companies have been ramping up capacity to produce high bandwidth memory (HMB) chips used to power AI applications (Figure 5). SK Hynix holds exclusive supply rights for certain HBM chips to Nvidia. In February, Samsung launched a 36GB 12-layer HBM3E, which boasts the industry’s fastest data processing speed among AI memory chips. This is expected to strengthen its market position, potentially securing a pivotal supply deal with Nvidia.

Figure 5: HBM market share is dominated by Samsung and SK Hynix

(Related article: Upgrade South Korea to 4 Stars: New Asian Tiger primed and ready for an export driven rebound)

EMXC: 24% upside potential

Considering the unique risk profile of the Chinese equity market, we believe it makes more sense to treat China as a standalone market. Investors of traditional EM products are typically forced to take on around 30% exposure to China. Opting for EM ex China investments allows investors to better manage their China risks.

In addition, EM ex China markets show significant growth potential, as they are key beneficiaries of long-term structural trends like deglobalisation and the rapid adoption of AI. As such, we believe investing in EM ex China is a long-term winning strategy.

Using a fair PE multiple of 14X, we project an upside potential of 24% for the MSCI Emerging Markets ex China Index, and a corresponding target price of USD 71 for the iShares MSCI Emerging Markets ex China ETF (NASDAQ:EMXC).

Figure 6: The index’s price has closely followed earnings

Table 1: Projections for the MSCI Emerging Markets ex China Index

	2023	2024E	2025E	2026E
PE Ratio (X)	16.6	14.1	12.1	11.3
EPS	227.6	274.7	318.4	341.0
Earnings Growth	-19.2%	20.7%	15.9%	7.1%
Target Price for EMXC ETF				USD 71
Potential Upside				24%
Source: Bloomberg Finance L.P., iFAST Estimates Data as of 8 March 2024

For investors looking to reduce their exposure to China while still keen on retaining exposure to EM markets with vast growth potential, the EMXC ETF is a solid option thanks to its high liquidity and low expense ratio of 0.25%. Its largest holdings include TSMC and Samsung Electronics, which are also the biggest contributors to the ETF’s performance over the past year (Table 2).

Table 2: Top 10 holdings of EMXC

Name	Market	Weight
TSMC	Taiwan	10.24%
Samsung Electronics	South Korea	5.01%
Reliance Industries	India	2.04%
Infosys	India	1.27%
ICICI Bank	India	1.25%
SK Hynix	South Korea	1.22%
MediaTek	Taiwan	1.04%
HDFC Bank	India	0.91%
Al Rajhi Bank	Saudi Arabia	0.88%
Vale	Brazil	0.88%
Total		24.74%
Source: BlackRock Data as of 29 February 2024

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.