Will China’s stimulus boost the economy?

The Chinese government’s policy announcements suggest a positive direction, but we expect the economic recovery will take time given significant structural issues, like the real-estate crisis. For context, excess real-estate inventory amounts to 20 trillion renminbi, dwarfing recent policy support of 300 billion renminbi.¹

The Chinese economy is currently experiencing deflation, and the government is working to improve consumer confidence. Several monetary measures have been implemented to boost consumption; these are positive steps, but in small doses. For instance, the help with mortgage repricing is insufficient to significantly improve household confidence. The 50 basis-point cut in outstanding mortgage rates could save households 150 billion renminbi in interest expenses annually, equivalent to just 0.3% of annual retail sales.²

We recently conducted an online survey across China.³ Among the respondents, 70% were employed, aged between 26 to 46, with middle income levels. When asked which event would be most likely to drive higher discretionary spending, 25% preferred a cash handout from the government, followed by subsidies for elderly care. More direct support to families is needed in China, but this has not yet been a primary focus of government policy.

Will the US Federal Reserve deliver a soft landing? How will global interest rates and monetary policy affect emerging markets?

The US economy shows resilience, which supports the possibility of a soft-landing scenario. Emerging markets are sensitive to US-dollar strength, and the possibility of lower rates and a weaker dollar could support higher capital flows into emerging markets.

US election result: what does it mean for emerging markets?

In 2024, we saw elections across key emerging markets as well as in the US. While the details of President-elect Donald Trump’s proposed new policies are unclear, tariffs and geopolitical tensions are likely to remain significant concerns. US-dollar strength is crucial for emerging markets as it affects flows. The outlook for the US dollar is mixed; a higher deficit may drive stronger rates and a stronger US dollar, but increased manufacturing competitiveness in the US requires a weaker dollar.

Emerging-market companies have been navigating similar environments of higher tariffs and tensions in recent years. Over the last decade, emerging markets have faced challenges, but we now see supply-chain diversification and innovation supporting domestic economies and global exports with stronger balance sheets and lower valuations.

Our focus is on a select group of well-priced compounding businesses in emerging markets which can benefit from the growth of domestic economies. We believe our preferred holdings have strong return potential and long growth runways.

What is the impact of the oil price on emerging markets?

The impact of rising oil prices depends on whether countries or regions are net importers or exporters. Asia, a net importer, is vulnerable to higher costs, inflation, and weaker currencies. However, tariffs, trade tensions, and President-elect Trump’s oil policies may help lower oil prices.

If debt-ridden Western countries rein back on their promises about sustainability goals, how will this affect emerging markets?

A reduction in commitments to sustainability could adversely affect emerging markets in several ways. These include impacts on exports, incremental investments, and the ability to drive positive change across emerging-market countries.

China supplies over 65% of the world’s renewable energy products, including solar panels and batteries.⁴ Reduced sustainability commitments from Western countries would pressure China’s green industry exports. Western countries’ dedication to sustainability has driven innovation and new investments in emerging markets, like foreign direct investment into Indonesia related to green energy. Furthermore, demands from clients in Western countries have pressured emerging markets to enhance their commitment to sustainability goals and targets. A rollback in Western commitments could reduce this pressure, ultimately having a negative impact on the global environment.

Where do you see the most interesting opportunities?

We see compelling opportunities in companies driving the digitalization of economies.

Several emerging-market companies are global leaders in driving transformation, particularly in artificial intelligence (AI). The valuations of emerging-market technology enablers lag developed-market technology sectors. AI is evolving globally and is expected to reshape numerous industries, including health care, media, and industrials. The global AI market is projected to grow from $86.9 billion in 2022 to $407 billion by 2027, representing a 36.2% annual growth rate.⁵ Leading US technology companies are set to invest hundreds of billions annually in building data centers to support the rise of AI. While AI processing chipmakers dominate headlines, high-bandwidth memory (HBM) is also crucial, with a Korean business leading in HBM manufacturing technology. Testing companies are vital for improving semiconductor yield and efficiency, and we see attractive prospects in two Taiwanese firms.

Consumer experiences are gaining market share in China and India. We currently have exposure to an Indian online travel operator deriving 30% of its revenue from air travel and 50% from hotels. Its growth is driven by increasing penetration, which remains low, and higher frequency of use. Online hotel booking penetration is growing from 20% towards the global average of 60% to 70%.

Sources:

1.         South China Morning Post, China needs to inject US$276 billion into property market to stabilize prices: Goldman Sachs, June 4, 2024. https://www.scmp.com/business/china-business/article/3265371/china-needs-inject-us276-billion-property-market-stabilise-prices-goldman-sachs

2.         Global Times, China’s central bank cuts existing mortgage rates to prop up housing market, stimulate economic growth, September 24, 2024. https://www.globaltimes.cn/page/202409/1320268.shtml

3.         Newton and Baidu, October 2024.

4.         Chartered Institute of Exports and International Trade, Chinese green tech exports grow to majority of world supply as global renewables shift slows, May 30, 2024.

5.         GlobalNewswire, Artificial Intelligence Market Worth $407.0 Billion By 2027, Growing At A CAGR Of 36.2%: Report By MarketsandMarkets, May 17, 2023. https://www.globenewswire.com/news-release/2023/05/17/2671170/0/en/Artificial-Intelligence-Market-Worth-407-0-Billion-By-2027-Growing-At-A-CAGR-Of-36-2-Report-By-MarketsandMarkets.html

Will China’s stimulus boost the economy?

The Chinese government’s policy announcements suggest a positive direction, but we expect the economic recovery will take time given significant structural issues, like the real-estate crisis. For context, excess real-estate inventory amounts to 20 trillion renminbi, dwarfing recent policy support of 300 billion renminbi.¹

The Chinese economy is currently experiencing deflation, and the government is working to improve consumer confidence. Several monetary measures have been implemented to boost consumption; these are positive steps, but in small doses. For instance, the help with mortgage repricing is insufficient to significantly improve household confidence. The 50 basis-point cut in outstanding mortgage rates could save households 150 billion renminbi in interest expenses annually, equivalent to just 0.3% of annual retail sales.²

We recently conducted an online survey across China.³ Among the respondents, 70% were employed, aged between 26 to 46, with middle income levels. When asked which event would be most likely to drive higher discretionary spending, 25% preferred a cash handout from the government, followed by subsidies for elderly care. More direct support to families is needed in China, but this has not yet been a primary focus of government policy.

Will the US Federal Reserve deliver a soft landing? How will global interest rates and monetary policy affect emerging markets?

The US economy shows resilience, which supports the possibility of a soft-landing scenario. Emerging markets are sensitive to US-dollar strength, and the possibility of lower rates and a weaker dollar could support higher capital flows into emerging markets.

US election result: what does it mean for emerging markets?

In 2024, we saw elections across key emerging markets as well as in the US. While the details of President-elect Donald Trump’s proposed new policies are unclear, tariffs and geopolitical tensions are likely to remain significant concerns. US-dollar strength is crucial for emerging markets as it affects flows. The outlook for the US dollar is mixed; a higher deficit may drive stronger rates and a stronger US dollar, but increased manufacturing competitiveness in the US requires a weaker dollar.

Emerging-market companies have been navigating similar environments of higher tariffs and tensions in recent years. Over the last decade, emerging markets have faced challenges, but we now see supply-chain diversification and innovation supporting domestic economies and global exports with stronger balance sheets and lower valuations.

Our focus is on a select group of well-priced compounding businesses in emerging markets which can benefit from the growth of domestic economies. We believe our preferred holdings have strong return potential and long growth runways.

What is the impact of the oil price on emerging markets?

The impact of rising oil prices depends on whether countries or regions are net importers or exporters. Asia, a net importer, is vulnerable to higher costs, inflation, and weaker currencies. However, tariffs, trade tensions, and President-elect Trump’s oil policies may help lower oil prices.

If debt-ridden Western countries rein back on their promises about sustainability goals, how will this affect emerging markets?

A reduction in commitments to sustainability could adversely affect emerging markets in several ways. These include impacts on exports, incremental investments, and the ability to drive positive change across emerging-market countries.

China supplies over 65% of the world’s renewable energy products, including solar panels and batteries.⁴ Reduced sustainability commitments from Western countries would pressure China’s green industry exports. Western countries’ dedication to sustainability has driven innovation and new investments in emerging markets, like foreign direct investment into Indonesia related to green energy. Furthermore, demands from clients in Western countries have pressured emerging markets to enhance their commitment to sustainability goals and targets. A rollback in Western commitments could reduce this pressure, ultimately having a negative impact on the global environment.

Where do you see the most interesting opportunities?

We see compelling opportunities in companies driving the digitalisation of economies.

Several emerging-market companies are global leaders in driving transformation, particularly in artificial intelligence (AI). The valuations of emerging-market technology enablers lag developed-market technology sectors. AI is evolving globally and is expected to reshape numerous industries, including health care, media, and industrials. The global AI market is projected to grow from $86.9 billion in 2022 to $407 billion by 2027, representing a 36.2% annual growth rate.⁵ Leading US technology companies are set to invest hundreds of billions annually in building data centres to support the rise of AI. While Nvidia’s AI-processing chips dominate headlines, high-bandwidth memory (HBM) is also crucial, with a Korean chipmaker leading in HBM manufacturing technology. Testing companies are vital for improving semiconductor yield and efficiency, and we see attractive prospects in two Taiwanese firms.

Consumer experiences are gaining market share in China and India. We currently have exposure to an Indian online travel operator deriving 30% of its revenue from air travel and 50% from hotels. Its growth is driven by increasing penetration, which remains low, and higher frequency of use. Online hotel booking penetration is growing from 20% towards the global average of 60% to 70%.

Sources:

1.         South China Morning Post, China needs to inject US$276 billion into property market to stabilise prices: Goldman Sachs, 4 June 2024. https://www.scmp.com/business/china-business/article/3265371/china-needs-inject-us276-billion-property-market-stabilise-prices-goldman-sachs

2.         Global Times, China’s central bank cuts existing mortgage rates to prop up housing market, stimulate economic growth, 24 September 2024. https://www.globaltimes.cn/page/202409/1320268.shtml

3.         Newton and Baidu, October 2024.

4.         Chartered Institute of Exports and International Trade, Chinese green tech exports grow to majority of world supply as global renewables shift slows, 30 May 2024.

5.         GlobalNewswire, Artificial Intelligence Market Worth $407.0 Billion By 2027, Growing At A CAGR Of 36.2%: Report By MarketsandMarkets, 17 May 2023. https://www.globenewswire.com/news-release/2023/05/17/2671170/0/en/Artificial-Intelligence-Market-Worth-407-0-Billion-By-2027-Growing-At-A-CAGR-Of-36-2-Report-By-MarketsandMarkets.html

Investing in Asia has historically been focused on growth opportunities by using the region as a play on global gross domestic product (GDP) and export growth.

Instead, we believe more attractive risk and reward characteristics can be found by focusing on income as well as growth in the region.

We advocate diversification into Asia and focus on companies that can continue to pay dividends during times of macroeconomic uncertainty. Dividends play a key role in total returns for Asian investors and are the bedrock of income strategies.

In the new regime of higher interest rates and inflationary pressures, there is likely to be more volatility. As such, we think it is important to be selective within any dividend-focused approach.

Coupled with a change in growth dynamics, investor perspectives on investing in Asia could also be changing. Over the last decade, China’s internet platform companies have become a large part of the benchmark. However, valuations have been affected by regulatory concerns. We think this illustrates one of the pitfalls of focusing only on growth strategies in the Asia region, where valuations are not grounded by dividends.

By way of example, our Asian income portfolios are currently overweight in Singapore, which plays host to many companies with strong balance sheets and decent payout ratios. There is a lot of wealth and trade that goes through Singapore from its neighbouring nations. Banks in the region also have well-capitalised balance sheets and the ability to sustain higher dividends for years to come.

Another overweight is Taiwan, on the basis of opportunities around its many technology companies. We also see merits in Indonesia, which in our view emerged from the so-called ‘taper tantrum’ of 2013 stronger from current account and fiscal perspectives. We see strong growth coming out of that economy and think this is likely to continue.

We also believe India offers significant potential given its long-term demographics, strong consumption and household income growth, as well as growing levels of urbanisation. In other parts of Asia, ageing populations are supportive for income strategies because, as people grow older, there is a greater need for income to fund them in retirement.

Chipping in

On a thematic level, the technology sector provides investment opportunities. We believe artificial intelligence (AI), or more specifically companies supplying the hardware for AI, present interesting opportunities. Many of the technology companies held in our Asian Income strategy have net cash balance sheets and pay dividends, and we expect the AI industry to increase dividends as profits grow in the coming years.

Overall, we are broadly looking for balance-sheet strength, strong business models, and companies that have economic moats that give a competitive advantage. In other words, we favour quality franchises, with a degree of pricing power, which maintain profitability and margins – and pay dividends. Especially with Asia, we think the capital growth component of a portfolio’s total return is more volatile and less dependable than the income component.

By harnessing the potential of dividends and dividend growth, it is possible to compound total returns in a more consistent fashion than by trying to target growth on its own.

A version of this article first appeared on Morningstar.co.uk

For the last two decades, I have conducted grass-roots research across emerging markets. My aim is to dig deep to understand how consumer needs are evolving and how those often-underserved needs can translate into long-term investment opportunities. During my latest visit to India, I met companies and conducted vendor interviews. I ran focus groups with students, women and small business owners in Jaipur and Lucknow to further our understanding of rural consumption trends and the social and economic environment. Here are my takeaways.

The Formalization of India’s Economy Is Accelerating

Government policy is accelerating formalization¹ across industries, with smaller non-compliant players being crowded out. The formalization of the economy is set to boost the government’s coffers, via increased tax revenues.

Formalization favors the largest established dominant industry players. As the biggest get stronger, and gain more market share, they also have scope for greater efficiency gains which, in turn, support growth and EPS (earnings-per-share) compounding.

A Mixed Consumption Environment: Premiumization at the Top but Widespread Disruption at the Bottom

The wealthiest set of consumers are incrementally spending, providing a supportive environment for hotels, jewelry and food-delivery companies.² However, digitalization is lowering barriers to entry and disrupting traditional distribution moats, driving product innovation and testing consumers’ loyalty to established brands, which creates a challenging environment for traditional multinationals.

Infrastructure-Led Growth, Private Capital Remains on the Side

Following India’s general election, the results of which are set to be declared on June 4, we could see some private capital expenditure (capex), but cash/excess capacity remains high. Broader consumption demand needs to grow in order to trigger additional private investments. Loan books are showing infrastructure-related capex, but private capital is on the side.

The trickle-down effect of greater infrastructure spending has benefited a number of small and medium-sized enterprises (SMEs) across the country. The momentum is strong, and the elections appear a safe bet, with Narendra Modi widely expected to secure a third term as prime minister. The regulator is conservative, which has led to a preventive pullback on consumer loans, but these represent only a small part of total loan books.

Giving the Non-Banked Financial Access Could Have a Significant Multiplier Effect across Emerging Markets

Focus groups, with students, women and small business owners in Jaipur and Lucknow, demonstrated how digitalization (the use of digital technologies to change a business model and provide new revenue and value-producing opportunities) and increasing access to financing are driving opportunities and aspirations across rural India.

In a village outside Jaipur, we met a banana wholesaler. Prior to getting access to loans, he would distribute his bananas on a pushcart. A vehicle-financing loan allowed him to start sourcing from multiple suppliers, and to expand his addressable market to several villages, rather than just one. Since the pre-Covid-19 period, when he had the pushcart, his sales have increased by ten times. He now distributes over 10 tons of bananas per month. 

Giving the non-banked financial access could have a significant multiplier effect across emerging markets. By 2023, India had over 64 million micro, small & medium enterprises that collectively accounted for approximately 30% of the country’s GDP.³ There are, however, multiple challenges inhibiting their growth, such as limited digitalization and difficulty accessing capital. This means that of the existing US$220bn credit demand, only $US53bn was injected into the markets through various lending channels, accounting for only 30% of the total addressable demand.⁴ In order to address this, smaller non-bank financial companies and small banks now seek to understand unbanked SMEs from a ‘boots on the ground’ perspective, rather than solely via data analytics. This means they are spending time with SMEs to understand their sales patterns and therefore what loan product is the best fit.

Digitalization Could Spur Social Mobility

Digitalization is unlocking intergenerational social mobility by providing access to education and job training. India’s female labor force participation rate has been among the lowest globally (at 24% – versus China/US/South Korea/UK, where rates range between 55% and 70%), which has stifled socioeconomic progress, particularly in rural India.⁵

We conducted focus groups in rural areas with women aged between 20 and 23. It was incredible to see the progressive mindset of these women in terms of the jobs they hope to secure, and how access to education through digital apps is unlocking opportunities. Furthermore, recruitment services apps, such as job portals, are breaking the physical barriers of social mobility, by ensuring more equitable access to labor markets. We spoke to several women who hope to obtain jobs, either in government, law or teaching, and are using job portals to build their CVs and learn more about the skills they need to achieve their aspirations.

Sources:

1. WIEGO https://www.wiego.org/rethinking-formalization

2. ICE360, Middle class brochure 2022, https://www.ice360.in/app/uploads/2022/11/middle-class-brochure-2022.pdf

3. Brookings Papers, BPEA Conference Drafts, March 30-31, 2023 https://www.brookings.edu/wp-content/uploads/2023/02/BPEA_Spring2023_EM-Panel_Acharya_unembargoed_updated.pdf

4. AU Small Finance Bank Integrated Annual Report 2022-2023

5. The World Bank

For the last two decades, I have conducted grass-roots research across emerging markets. My aim is to dig deep to understand how consumer needs are evolving and how those often-underserved needs can translate into long-term investment opportunities. During my latest visit to India, I met companies and conducted vendor interviews. I ran focus groups with students, women and small business owners in Jaipur and Lucknow to further our understanding of rural consumption trends and the social and economic environment. Here are my takeaways.

The formalisation of India’s economy is accelerating

Government policy is accelerating formalisation¹ across industries, with smaller non-compliant players being crowded out. The formalisation of the economy is set to boost the government’s coffers, via increased tax revenues.

Formalisation favours the largest established dominant industry players. As the biggest get stronger, and gain more market share, they also have scope for greater efficiency gains which, in turn, support growth and EPS (earnings-per-share) compounding.

A mixed consumption environment: premiumisation at the top but widespread disruption at the bottom

The wealthiest set of consumers are incrementally spending, providing a supportive environment for hotels, jewellery and food-delivery companies.² However, digitalisation is lowering barriers to entry and disrupting traditional distribution moats, driving product innovation and testing consumers’ loyalty to established brands, which creates a challenging environment for traditional multinationals.

Infrastructure-led growth, private capital remains on the side

Following India’s general election, the results of which are set to be declared on 4 June, we could see some private capital expenditure (capex), but cash/excess capacity remains high. Broader consumption demand needs to grow in order to trigger additional private investments. Loan books are showing infrastructure-related capex, but private capital is on the side.

The trickle-down effect of greater infrastructure spending has benefited a number of small and medium-sized enterprises (SMEs) across the country. The momentum is strong, and the elections appear a safe bet, with Narendra Modi widely expected to secure a third term as prime minister. The regulator is conservative, which has led to a preventive pullback on consumer loans, but these represent only a small part of total loan books.

Giving the non-banked financial access could have a significant multiplier effect across emerging markets

Focus groups, with students, women and small business owners in Jaipur and Lucknow, demonstrated how digitalisation (the use of digital technologies to change a business model and provide new revenue and value-producing opportunities) and increasing access to financing are driving opportunities and aspirations across rural India.

In a village outside Jaipur, we met a banana wholesaler. Prior to getting access to loans, he would distribute his bananas on a pushcart. A vehicle-financing loan allowed him to start sourcing from multiple suppliers, and to expand his addressable market to several villages, rather than just one. Since the pre-Covid-19 period, when he had the pushcart, his sales have increased by ten times. He now distributes over 10 tonnes of bananas per month. 

Giving the non-banked financial access could have a significant multiplier effect across emerging markets. By 2023, India had over 64 million micro, small & medium enterprises that collectively accounted for approximately 30% of the country’s GDP.³ There are, however, multiple challenges inhibiting their growth, such as limited digitalisation and difficulty accessing capital. This means that of the existing US$220bn credit demand, only $US53bn was injected into the markets through various lending channels, accounting for only 30% of the total addressable demand.⁴ In order to address this, smaller non-bank financial companies and small banks now seek to understand unbanked SMEs from a ‘boots on the ground’ perspective, rather than solely via data analytics. This means they are spending time with SMEs to understand their sales patterns and therefore what loan product is the best fit.

Digitalisation could spur social mobility

Digitalisation is unlocking intergenerational social mobility by providing access to education and job training. India’s female labour force participation rate has been among the lowest globally (at 24% – versus China/US/South Korea/UK, where rates range between 55% and 70%), which has stifled socioeconomic progress, particularly in rural India.⁵

We conducted focus groups in rural areas with women aged between 20 and 23. It was incredible to see the progressive mindset of these women in terms of the jobs they hope to secure, and how access to education through digital apps, such as YouTube and Facebook, is unlocking opportunities. Furthermore, recruitment services apps, such as job portals, are breaking the physical barriers of social mobility, by ensuring more equitable access to labour markets. We spoke to several women who hope to obtain jobs, either in government, law or teaching, and are using job portals to build their CVs and learn more about the skills they need to achieve their aspirations.

Sources:

1. WIEGO

https://www.wiego.org/rethinking-formalization

2. ICE360, Middle class brochure 2022,

https://www.ice360.in/app/uploads/2022/11/middle-class-brochure-2022.pdf

3. Brookings Papers, BPEA Conference Drafts, March 30-31, 2023

https://www.brookings.edu/wp-content/uploads/2023/02/BPEA_Spring2023_EM-Panel_Acharya_unembargoed_updated.pdf

4. AU Small Finance Bank Integrated Annual Report 2022-2023

5. The World Bank

For the last two decades, I have conducted grass-roots research across emerging markets. This has taken me from Brazil to Kenya, and I have convened focus groups and spoken to hundreds of consumers in many different countries. My aim is to dig deep to understand how consumer needs are evolving and how those often-underserved needs can translate into long-term investment opportunities. I look for companies which are the beneficiaries of long-term structural forces – either domestic champions or companies that are taking a growing share of global industries. It is an approach which is inherently thematic in nature, and in a way less correlated to economic cycles in emerging markets.

I have visited China often – two or three times per year while living in Singapore for the last seven years. I was excited to return to Shanghai and Hangzhou in January, where we met companies, industry experts and consumers. I have three key takeaways.

1        Challenging economic outlook

China’s economic recovery post Covid has been slow and uneven, and the economic outlook remains challenging. While the narrative over the last year has been focused on the economy’s disappointing performance after reopening, I think it is more pertinent to understand the changes that were occurring in the country pre-Covid and how they point to future opportunities. I believe the focus of government policy will remain on narrowing the income gap, facilitating wealth redistribution and encouraging greater self-sufficiency. Taken together, these three factors are likely to lead to moderate economic growth, a focus on lower-income sections of the population, and policy support for industries driving self-sufficiency.

2        Growth, franchise and governance

Our investment process uses a quality framework which looks at opportunities from the point of view of growth, franchise and governance characteristics. Following my trip, I believe the biggest change relates to the shifting composition of growth. Specifically, growth is lower and more widely dispersed across different sectors. The typical franchise remains the same, with domestic competition and overcapacity persistent, but some exporters remain highly competitive. Governance is broadly unchanged but there is a silver lining; as growth moderates, management teams’ messaging during our meetings was more focused on returns, cash-flow generation and prudent capital allocation. It will be a positive if this can point to better governance in the future.

3        China – a new playbook

To evaluate opportunities in China, we believe it is important to understand the new playbook. While the last decade was about the wealth creation of the top 20% tier, the policy focus has now shifted to the remaining 80%. Consumers in the lower tier are more focused on value for money and, in a way, less brand-oriented versus higher-tier consumers.

In terms of sector preferences, our view is to be selective on consumer exposure, with a preference for companies that are addressing demands of lower-tier consumers. We are also focused on services taking incremental wallet share, especially in older cohorts. We are selective on industrials and focus on opportunities driven by self-sufficiency needs or global competitiveness, with the right balance of quality and price. We also see opportunities given the reallocation of savings, for example from real estate to insurance.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Key points

• We are witnessing a divergence between the outlook for developed-market and emerging-market inflation.
• China is playing a key role as an exporter of lower inflation to emerging markets as trade and investment integration increases within the bloc, just as China’s trade with the US and many western countries reduces.
• Many developed-market central banks continue to tackle above-target inflation following an extended period of excessive monetary and fiscal easing, trade protectionism, labour-market tightness and continuing supply-chain disruptions.
• Conversely, many emerging markets avoided excessive monetary and fiscal stimulus during the pandemic and, when global inflationary pressures were rising in 2021 and 2022, positioned themselves ahead of the curve in terms of hiking interest rates.
• We believe that lower emerging-market inflation dynamics will enable central banks to reduce rates further than consensus estimates, boosting emerging-market local-currency bond returns and providing the conditions for a lower cost of capital to support emerging-market equity markets.

Diverging inflation dynamics

The world is facing very different inflation dynamics as a divergence between the outlook for developed-market and emerging-market inflation takes place. At the heart of this dynamic is China’s role as an exporter of lower inflation to emerging markets as trade and investment integration increases with the bloc.

Cheaper emerging-market commodity availability, owing to Russia being shut out of developed markets, is also a boon to emerging-market inflation. We believe that lower emerging-market inflation dynamics will enable central banks to reduce rates further than consensus estimates, boosting emerging-market local-currency bond returns and providing the conditions for a lower cost of capital to boost emerging-market equity markets.

Excessive monetary and fiscal easing in developed markets

While most developed-market central banks continue to tackle above-target inflation following an extended period of excessive monetary and fiscal easing, trade protectionism, labour-market tightness and continuing supply-chain disruptions, the dynamics facing many emerging markets stand in stark contrast. Many of the latter avoided excessive monetary and fiscal stimulus during the Covid pandemic and, when global inflationary pressures were rising in 2021 and 2022, they positioned themselves ahead of the curve in terms of hiking interest rates.

Furthermore, emerging markets have generally remained more open to free trade and less protectionist, and output gaps (particularly in certain Asian economies) have remained negative, which has eased the inflationary burden. While we expect inflation in developed countries to come down in the near term, we believe that it will remain volatile and prone to upward spikes as experienced during the 1970s. This is partly because western central banks will come under increasing political pressure to reduce interest rates at the earliest opportunity and partly because we now live in a volatile geopolitical world in which cost-push supply shocks are an increasing phenomenon. However, if there is one inflationary dynamic that will favour structurally lower price rises in the emerging world versus the developed, it is the former’s constructive trade and investment relationship with China, while the developed world continues to reduce ties and increase protectionism.

China – exporter of low inflation

China experienced consumer price deflation over the second half of 2023 and producer price deflation for the whole of 2023. Since the Covid pandemic, Chinese consumers have saved an extra 4% of their incomes on average. Savings rates were already high in China but remain extremely elevated at 35% of disposable income (see chart below).

China household savings rate (% of disposable income)

Source: Macrobond, January 2024

Because of China’s economic model and long-term high savings rates, the country has had a historically high level of investment to GDP. This time around, however, investment in the real-estate sector is off limits owing to the policies and resulting downturn in this sector. Instead, investment has been increasingly channelled into manufacturing investment to fulfill the Chinese Communist Party’s quality-growth target (see chart below).

China’s fixed-asset investment in manufacturing (cumulative year-on-year over last five years (%)

Source: Macrobond, January 2024

Such high levels of manufacturing investment have resulted in excess industrial capacity in certain sectors, thereby causing producer price deflation and affecting industrial profits (see chart below).

China’s industrial capacity utilisation v producer price inflation (PPI) and industrial profit growth

Source: Macrobond, January 2024

Because China is producing more than its domestic requirements, the resulting increase in exports has led the country’s trade surplus to surge over the last few years to an annualised level of c.US$450bn (see chart below).

China’s trade balance (billions of US dollars)

Source: Macrobond, January 2024

Developed-market versus emerging-market protectionist response

The consequence for China of operating such an economic model (i.e. insufficient domestic consumption, excessive domestic investment, large state subsidies) is that it risks upsetting trade partners. Large tariffs remain in place from the US, and we suspect that these are only likely to increase under a potential ‘Trump 2.0’ administration. Meanwhile, the European Union (EU) announced an investigation into Chinese electric vehicle state support and unfair competition in the fourth quarter of 2023. While the US and EU still comprise more than 25% of China’s total exports, this share has been declining in recent years. (See chart below).

Changing destination of Chinese exports between 2017, 2021 and 2022

Source: World Bank, Trading Economics, Newton Investment Management, January 2024

We contend that the majority of China’s trade partners in the ‘Global South’ (non-G7 countries) want open trade with China and are less likely to resort to protectionist measures. This is in large part because China buys their commodities and invests in their infrastructure. In the case of Asia, China is part of the Regional Comprehensive Economic Partnership (RCEP) trade group, which was established in 2020, with the aim of reducing tariffs between members. The group is comprised of 15 countries representing 30% of global GDP and growing.

As Chinese trade and investment integration with both the RCEP and African and Latin American countries grows, China will be exporting lower inflationary forces, thereby helping to keep interest rates lower across the emerging-market bloc. We believe this is good news for emerging-market local-currency bonds, which we expect to perform strongly over the coming months. By contrast, protectionist measures by the G7 will continue to limit China’s incremental access to these markets, which means the G7 will miss out on the lower goods price inflation that China can provide. (See chart below).

Developed-market versus emerging-market inflation (%)

Russia’s role

While this article has focused primarily on the disinflationary impulse from China to other emerging markets in the bloc, Russia is playing a similar role in the commodities sphere. With Russian commodity exports locked out of G7 markets, Russian oil, gas, food and metals have been diverted to emerging markets, often at steep discounts to international benchmark pricing, as Moscow’s customer base was curtailed. Given the continuing war in Ukraine and Moscow’s ascendency on the battlefield, it is unlikely that this commodity export dynamic will change in the near to medium term.

Investment implications

While conditions in developed markets point towards more elevated and volatile inflation over the next decade in a potential echo of the 1970s, we believe that inflationary conditions in many major emerging markets are very different, owing to disciplined and proactive monetary and fiscal policy, less tight labour and industrial markets and, most importantly, constructive trade relations with China (and to a lesser extent, Russia). This will help reduce the emerging-market local-currency cost of capital, which could be a benefit to both emerging-market local-currency bond and equity holders. In our view, investors should consider being overweight in both emerging market (ex China) bonds and equities in 2024.

For the last two decades, I have conducted grass-roots research across emerging markets. This has taken me from Brazil to Kenya, and I have convened focus groups and spoken to hundreds of consumers in many different countries. My aim is to dig deep to understand how consumer needs are evolving and how those often-underserved needs can translate into long-term investment opportunities. I look for companies which are the beneficiaries of long-term structural forces – either domestic champions or companies that are taking a growing share of global industries. It is an approach which is inherently thematic in nature, and in a way less correlated to economic cycles in emerging markets.

I have visited China often – two or three times per year while living in Singapore for the last seven years. I was excited to return to Shanghai and Hangzhou in January, where we met companies, industry experts and consumers. I have three key takeaways.

1       Challenging Economic Outlook

China’s economic recovery post Covid has been slow and uneven, and the economic outlook remains challenging. While the narrative over the last year has been focused on the economy’s disappointing performance after reopening, I think it is more pertinent to understand the changes that were occurring in the country pre-Covid and how they point to future opportunities. I believe the focus of government policy will remain on narrowing the income gap, facilitating wealth redistribution and encouraging greater self-sufficiency. Taken together, these three factors are likely to lead to moderate economic growth, a focus on lower-income sections of the population, and policy support for industries driving self-sufficiency.

2       Growth, Franchise and Governance

Our investment process uses a quality framework which looks at opportunities from the point of view of growth, franchise and governance characteristics. Following my trip, I believe the biggest change relates to the shifting composition of growth. Specifically, growth is lower and more widely dispersed across different sectors. The typical franchise remains the same, with domestic competition and overcapacity persistent, but some exporters remain highly competitive. Governance is broadly unchanged but there is a silver lining; as growth moderates, management teams’ messaging during our meetings was more focused on returns, cash-flow generation and prudent capital allocation. It will be a positive if this can point to better governance in the future.

3       China – A New Playbook

To evaluate opportunities in China, we believe it is important to understand the new playbook. While the last decade was about the wealth creation of the top 20% tier, the policy focus has now shifted to the remaining 80%. Consumers in the lower tier are more focused on value for money and, in a way, less brand-oriented versus higher-tier consumers.

In terms of sector preferences, our view is to be selective on consumer exposure, with a preference for companies that are addressing demands of lower-tier consumers. We are also focused on services taking incremental wallet share, especially in older cohorts. We are selective on industrials and focus on opportunities driven by self-sufficiency needs or global competitiveness, with the right balance of quality and price. We also see opportunities given the reallocation of savings, for example from real estate to insurance.