Drop in commodities, end of 'Chinese exceptionalism' to create new challenges
Emerging markets have seen steady growth over the past two decades, as the rise of China as a superpower and the emergence of India as a major world player has lifted the valuation of emerging markets.
However, Ashish Dewan suggests that the previous insulation from volatility seen in developed markets could soon be dimming for emerging markets. Dewan, senior investment strategist at Vanguard, points to China’s recent economic hiccups and a potential end to previous commodity booms that spurred emerging markets in the past.
“We don't see earnings growth as being as robust going forward as it was in the last two decades,” he said. “In the last two decades, we saw very strong earnings in emerging markets. And there were two reasons for that. The first reason was China exceptionalism. And the second reason was strong commodities.”
The Vanguard FTSE Emerging Markets ETF is weighted heavily in Asia, with China, India and Taiwan making up over 70 per cent of the ETF’s fund. With China and Taiwan playing such a crucial role in the performance of emerging markets as a whole, Dewan cautioned that geopolitical tensions in the South China Sea could further complicate growth in emerging markets.
Strength in the commodity sector has in the past largely shielded Asian emerging markets from inflation, though this is changing as local economies become more service and consumer-oriented, according to Dewan. He says this could leave the emerging markets increasingly vulnerable to the impacts of inflation, particularly if tariffs are elevated and inflation remains persistent.
Dewan suggests that investors should still hold emerging markets, but think about keeping it as a minor component of their portfolios. He says the fundamental benefits of emerging markets – including the possibility of navigating away from other markets’ volatility – remain, even if he is not as bullish on emerging markets now compared to the past.
“Emerging markets are going to bring some correlation benefits in investors’ portfolios, so they add diversification,” he said. “And even though the individual volatility of the asset class might be high, it can dampen total portfolio volatility because of the non-perfect correlation between emerging markets and other markets. So we advise our clients to still have an allocation to emerging markets.”
Since Trump announced his sweeping tariff policies in February, investors have left US markets in droves to seek safety from the volatility and uncertainty caused by the president’s tariffs. And while this development would on the surface seem to give significant tailwinds to emerging markets, Dewan suggests that investment opportunities look brighter in developed Ex-US markets such as the EU, the UK and Japan. He points to the breaking of Germany’s debt barriers for defence spending, and says that while Ex-US markets do not see the same boosts from the technology sector, their earnings and growth prospects are still higher than those of emerging markets.
“What we see in the developed Ex US market is that balance sheets and income statements for firms actually have a lot of room to grow. So given all those tailwinds, we are more optimistic about developed Ex-US than emerging markets,” he said.
China’s trade dispute with the US has taken centre stage in recent months, though Dewan points to difficult trade relations with countries around the world, including Canada. He says that if other major economies decide to change their trade relations with China, it will cause a dilemma of excess capacity with nowhere to send goods. Dewan also notes China’s aging population and decreasing consumer spending due to economic struggles from its real estate crisis, which has been ongoing since the default of Evergrande Group in 2021.
“US economy hiking tariffs, that's all been front and centre of the news. But what if other economies start having higher tariffs on China?” he said. “Because now China has all this excess capacity, and they can't really sell all that excess capacity, because the US is no longer a reliable trade partner.”
With regards to India – which makes up 22 per cent of Vanguard’s ETF – Dewan suggests there are both signs of strength and weakness in the world’s most populated country. A growing middle class, young population and implementation of tech have bolstered the country’s value, while it has also is less reliant on global trade than China given its massive consumer demand. However, Dewan emphasizes the challenges created by a largely disjointed nation where states tend to act in an isolationist fashion, while regulatory barriers also remain burdensome.
“The Indian states push their own initiatives forward and they don't work in unison as a strong country,” he said. “But there's tailwinds too. There's a very strong, growing middle class and been on the forefront of adopting a lot of technological initiatives.”
