With China looking fragile, what’s in store for EMs?

Portfolio manager breaks down China's slow-drip stimulus approach to recovery, and why EM ex-China exposure is making sense

With China looking fragile, what’s in store for EMs?

There’s been plenty of ink spilled over China’s slowdown, with rampant speculation about its overreliance on property and financial fragility. But to Regina Chi, vice president and portfolio manager at AGF Investments, what the world is witnessing is not necessarily an inevitable collapse.

“I really believe this is a cyclical slowdown, rather than a structural issue,” Chi said in a recent conversation with Wealth Professional. “However, we need more reforms that will rebalance the economy to prevent it from becoming a structural downturn.”

‘China is using its bullets carefully’

While China’s fading economic glow has stoked concerns among investors, Chi notes this isn’t the first cycle in which an emerging market has faced adverse conditions. South Korea’s history, she observes, includes numerous tribulations such as the debt crisis in 1982 and the Asian financial crisis, and has powered through.

“This is what we're seeing in China. They had one of the most draconian COVID lockdowns, and they had this about-face reopening led by social protests,” Chi says. “What we’ve found in the middle of the year from March to now is that there's deep scarring that's impacted the Chinese consumers and businesses … that confidence has effectively been completely shot.”

Now, China’s in the process of carefully rebuilding that confidence via the dripping out of monetary and fiscal stimulus, as it “does not want to do a big bazooka that they have done in the past, because [it’s] had an overreliance on fixed-asset investments.” Coming out of the recent mid-autumn festival, consumption in the country is still muted, prompting the Chinese government to contemplate even more stimulus measures.

“We'll see what types of tools they're going to come out with in terms of stimulating consumption,” Chi says. “They could do a trillion renminbi debt swap replacing maturing LGFV debt with refinancing bonds which will mitigate near-term liquidity risks. There's a lot more that could be done, but I think China is using its bullets very carefully.”

Data from August include some silver linings, with better-than-consensus reports in industrial production as well as retail sales. September also brought a positive surprise in industrial profits, with manufacturing PMI surpassing 50 for the first time in a while. With August-September growth momentum bottoming out, Q3 GDP growth rebounded sequentially, leading to a better-than-expected year-on-year growth of 4.9%.

Investors would also do well to keep a global perspective, Chi says, noting that inflation in China is massively contained relative to others. “China’s economy is still growing at about 5% of GDP, when the rest of the world is at under 0.5%-1.0%,” she adds. “This is a slowdown for them, but certainly much higher relative growth versus the rest of the world.”

The growing case of EM ex China

Looking at emerging markets more broadly, Chi says stripping out China shows EMs as a group are actually faring quite well, with a notable dispersion in returns. Recently, AGF Investments came out with the AGF Emerging Markets ex China Fund, which gives investors the opportunity to look beyond the Asian economic superpower.

The one-year time frame ending in the second week of October shows the MSCI Emerging Markets ex-China index 13.4%, compared to 11.5% for the whole EM index and just 7.1% for China alone.  

“Over a 10-year period, EM ex China has been up 19.5%, beating China by two percentage points,” she says.

China’s domestic issues, Chi says, has had minor negative impact on other EM regions. There’s in fact been some beneficial spillover effects to Mexico, where the stock market is up 13% year-to-date as the nearshoring trend sees businesses reducing their China risk by moving supply chains to friendlier shores.

“Tesla announced in March that they plan to build a plant in Monterrey. And Mexico has now replaced China as one of the top exporters to the United States,” she says.

“What we're seeing is a slow divorce occurring between China and the rest of emerging markets’ growth prospects and stock markets,” Chi says.

“However, I don't believe that there's going to be full decoupling; I am not in that camp. But I think that there will be a China plus one or two strategy that'll use China as a very large manufacturing base but will continue to diversify into other countries like Mexico and India. And so from that perspective, EM ex China may continue to outperform the broader emerging market complex.”