Who cares about emerging markets?
Photo by Yiran Ding on Unsplash
First, a mea culpa.
The title of this blog post was consciously designed to suck you into our world. We enjoy asking unsettling questions because they challenge us to gain deeper understandings of “truths”, which are often simply stories that have become naturalised through repetition and institutional convenience.
As many of you will know, we cut our teeth in emerging markets. It’s a world we love, with a very special community of people and firms that are capable of creating huge amounts of value for investors and themselves. But it’s also fair to say that the worldview of emerging markets has become static. It’s an investment sub-category that has enjoyed huge growth and consolidation, becoming part of the furniture for the world’s largest allocators.
But we think that there is something very wrong with this approach. While we have been involved, emerging markets have gone from being a narrative of excitement and growth to one of cyclical opportunity at the mercy of the index providers. You want some Chinese internet? There’s an ETF for that. You want Indian consumer? Yep there’s one for that too. The ETF assortment is large and choices are aplenty, and this is distorting emerging markets as an asset class.
What constitutes “emerging”, anyway?
Emerging markets arrived on the scene as a distinct equity segment with the launch of the MSCI Emerging Markets Index in December 1987. We believe everyone at Three Body Capital was alive back then, although Eugene is cutting it fine! At launch, the index included 10 countries and made up less than 1% of the global equity market (MSCI All Country World Index). The rest is history, and the MSCI EM index now comprises 24 countries and represents almost 12% of the MSCI ACWI Index.
Back in April 2019 we wrote an opinion piece on the blog lamenting the gradual demise of EM as an allocation category along with our view that traditional categories are dissolving, and we wanted to return to this topic with a specific focus on country weightings in the major EM indices.
Although indices like MSCI and FTSE continue to classify China as “emerging”, it’s becoming increasingly obvious to us that China may already have outgrown the tag. Okay, both MSCI and FTSE (amongst a series of other criteria) use Gross National Income (GNI) per capita thresholds (measured in US$ and adjusted in line with price inflation) to determine which countries are emerging, developed and frontier markets (and MSCI requires countries to have a GNI per capita 25% above the World Bank high income threshold for 3 consecutive years, amounting to US$ 15,294 per capita). The 2017 high income threshold was US$ 12,235 per capita, much higher than the average in China of US$8,690. So on this basis, there is much wood left to chop before China gets anywhere near to achieving developed market status. We are not here to quibble with FTSE and MSCI as they need their categorisation criteria and by the measures they apply, the results are apparent. But realistically speaking, is China really still an emerging market?
Market share.
First – a few obvious observations.
Many things about what China does are quite rightly up for intense debate, but there is no doubt that China already enjoys huge influence on the world stage, projecting political and economic power outwards with increasing bravado. Its economy has rapidly gained ground on that of the US, though we’re not going to guesstimate when the smaller economy will overtake the larger, or even if it will at all. That depends on simply too many variables today. Suffice to say China’s economy has matured rapidly from an export driven model to one that prioritises domestic demand. It has the largest population (home to 18.5% of the world's people), the second largest land area (7% of the world’s land) and it is the third strongest military power (for now).All of this is quite rightly reflected in China’s rising contribution to the MSCI EM index, which has grown from 0% before 1996 to a whopping 33% in March 2019, making it by far the largest country represented. In late November, MSCI added 204 China A shares to bring the China country weight to 33.7% of the EM index. And BMO has observed that if MSCI includes not only include A-shares traded via Stock Connect, but all free float onshore A-shares, the Chinese equity market would be US$3.5bn, making up roughly half of the EM index.
China may not have taken over the world just yet, but it’s taking over the index. As the “Reformed Broker” Joshua Brown has observed, “most emerging markets indexes are often China funds in disguise”.
So you want to be an EM fund manager?
It seems almost laughable to call China an “emerging market”, especially given how far ahead it is compared to many “developed” countries in many areas. We talk about China and the US today in the context of the Thucydides Trap. Most people consider China as a potential superpower and yet MSCI and FTSE classify China as an emerging market, according to their own predetermined criteria, of course. The investment management landscape continues to happily go along with this story (just following the guidelines, keep calm and carry on) because it perpetuates the status quo – at least, it has done until now. But China’s allocation in the index, weighted by the market capitalisation of its companies, is distorting the broader EM asset class, with implications that go far beyond the daily machinations of fund managers and allocators. If you want to be an EM fund manager you had better forget all your years learning about places like Turkey, Indonesia, Poland, Russia, South Africa and other fascinating markets and quickly upskill on China – it will soon account for 50% of the index, so best you ingest thousands of years of history, culture and language, fast. Nevermind local market knowledge and nuance.
China’s rise in the index weightings is no coincidence – Chinese policymakers have lobbied hard to get more names included in major indices, improving access to liquidity from institutional investors. This itself speaks of great power. But their gain is other countries’ loss.
Not only does China’s dominance over the main EM indices reduce capital inflows from foreign investors and much needed liquidity to exchanges, depriving other EM countries of investment. It also starves important markets from investor attention – research, trading, and intangible opportunities to connect and build relationships.
For their part, investors are faced with increased concentration (and specialisation) risk. Everyone piles into (and out of) the same names at the same time, exacerbating price distortions and ultimately making it harder for everyone to navigate primary markets and raise capital at a cost-effective level.
What next for EM as a category?
So, what of the future? China isn’t joining the developed market indices anytime soon. If and when it is upgraded, one hopes that the biggest winners won’t necessarily be Chinese companies – it might be firms in other emerging markets, which will benefit from increased inflows and investor focus. Or, the market might just not care about who gets left behind. We won’t know until it happens.
But let's be honest: this isn’t only about China. South Korea and Taiwan account for 24% of the MSCI EM Index too. Are these countries really emerging markets? Right now nearly 60% of the index comprises companies from the above three countries. This raises the question – what do emerging markets even stand for anymore? Long gone are the days of broad-based, breakneck growth opportunities running on the tailwinds of country macro and structural reform.
Let’s look at the data, which shows what happened to flows over the past 20 years or so. For all the sex appeal of emerging market investing, the flows tell a very different story.
(To be honest, we had an inkling that this might be true, but when we actually looked at the data the message was much more stark than initially expected.)
The flows indicate that the emerging markets narrative is well and truly dead. The chart above shows the outflows following the bull market in the 90s and the subsequent bull market in the first decade of the 2000s. Since then the tale has been one of pure woe. Apart from a brief and spectacular surge in 2016 and a small uptick this year, it appears that the structural narrative of emerging markets as a group is dead.
What is dead may never die.
“What is dead may never die.”
Theon Greyjoy during his iconic baptism scene in the HBO series, Game of Thrones
The emerging markets story has been dead for some time, but they have been petrified in time by the efforts of index providers and the industry that surrounds them. Because the index is there, it never dies. Its composition has changed dramatically as we have written about above, but the dance continues.
Some of the best fund managers in the business, many of whom we know, have had excellent performance for years, yet they have seen very little interest from investors. Does this mean that no one is even watching? Are the people who are investing in the ETF today looking for the sexy growth story as it used to be, or are they simply looking for an easy instrument to trade and punt the global cycle?
Are we talking ourselves out of a job?
Our view is that any grouping of stocks, sectors, or countries together is usually transient and that “emerging markets” as a buzzword has passed its expiry date. What emerging markets have always been about is growth and excitement. To capture this essence in the current incarnation of EM, one needs fewer positions, more carefully chosen, quite simply because fewer opportunities in the form of classic EM growth exist. We don’t need to have long positions in China just because MSCI says we should. We can happily short Russian stocks should we deem it appropriate per our investment process. And should we find digital assets to be the opportunity we suspect it might be, we want the freedom to be able to add positions (long and short) in an emerging ecosystem which may prove extremely lucrative whatever that investment subcategory may be called.
We are building a fund which invests not only in emerging markets but in emerging opportunities.
Our view is that there is always a bull market somewhere. We look for growth wherever we can find it.
Should Turkey have a positive political event, we will delightfully build positions there. Should Iran be reintegrated into the global sphere, we will be there too if our process takes us there. And China? Selectively and carefully there are great opportunities, both long and short.
So of course there will be a focus on the traditional emerging market geographies because there is still a lot of opportunity there. It is just that it is no longer as pervasive as it once was and we certainly aren't looking to MSCI to tell us how to go about constructing our portfolio. The opportunity set is far bigger than buzzwords and archaic top-down classifications and we believe that our history, our personalities and our investment process will deliver to us and our investors the returns that we seek.
Many readers will balk at this note, having been in the industry for a long time, but the elephant in the room should be called out. We are always available and would be delighted to discuss our thoughts on emerging opportunities any time as we work towards our fund launch in early 2020.