Evergreen avoiding Evergrande

Emerging markets have been in the news with concern about the contagion impact of the  potential failure of Chinese property developer Evergrande. This crisis highlights the importance of being selective in emerging markets and avoiding those old economy sectors like real estate and financials, as the Chinese government pivots toward domestic consumption, new economy sectors and ‘common prosperity’.

Emerging markets can be a rocky ride and recent volatility can provide an ideal entry point. Astute investors allocate to emerging markets to capture this long-term growth opportunity as part of a well-diversified international portfolio strategy.

It is important to be selective because not all emerging markets companies are desirable from an investment perspective and identifying those companies best positioned to perform through the cycle is difficult.

Being selective in emerging markets

The biggest growth story with emerging markets over the past 20 years has been China. China has been driving global economic growth, but growth there is now at risk due to the collapse in Evergrande. Evergrande is China’s largest property developer by bond market issuance and it is trying to restructure its debt. But China’s property sector woes are just starting and a government rescue package may be at odds with its stated policy. China’s ‘common prosperity’ policy is focused on lower housing prices and delivery of units.

Evergrande has come at a time when Chinese growth was already faltering. Property represents 20% of GDP growth. Chinese growth could get hit. As you can see in the chart below, this challenge in the property sector could point to a Chinese downturn.

It is important to be selective in China and in broader emerging markets. Investing in emerging markets rewards investors with long investment timeframes who are willing to ride these peaks and troughs. Those sectors that have been affected most by the fallout from the collapse of Evergrande are real estate and finance.

Emerging markets generally trade at a discount to developed markets to reflect the additional risk. We do note that the difference between emerging markets and developed markets price-to-equity (P/E) multiples have been hovering around levels similar to the difference in 2017. Emerging markets may be due to break out.

2017 was a breakout year for emerging markets

Since 2001, emerging markets have outperformed developed markets, but it has been a wild ride. Australian investors with global equity portfolios that had exposure to emerging market equities were rewarded in the lead up to the GFC (2001 to 2007 below) benefiting from the emerging markets boom. They then underperformed, prior to a stellar 2017. Since then, emerging markets have underperformed developed markets in the wake of a relatively stronger US dollar and the COVID-19 pandemic.

However, the outlook is positive with tailwinds for emerging market equities. As global economies start to re-emerge and grow, so too will demand for emerging markets’ exports. There continues to be downward pressure on the US dollar with the US Fed continuing to delay tapering and a weaker dollar benefits exporting economies. 

This bodes well for emerging markets.

Table 1: Return comparisons between emerging markets equities and developed markets indices since 2001