What do emerging markets look like without China? Derrick Irwin, portfolio manager with the Intrinsic Emerging Markets Equity team, and Joseph Dore, head of International Consultant Relations, discuss the emergence of EM (emerging markets) equity ex China.


Derrick Irwin: An EM (emerging markets) ex China mandate would allow investors to express their unique long-term views in a more targeted manner to access those opportunities.

Joseph Dore: That’s Derrick Irwin, portfolio manager with the Intrinsic Emerging Markets Equity team here at Allspring Global Investments. I’m Joseph Dore, head of International Consultant Relations, and you’re listening to On The Trading Desk®. Today, we’re discussing the emergence of emerging market equity ex China. Thanks for being here today, Derrick.

Derrick: Hi, Joe. It’s good to be here.

Joseph: Let’s talk very big picture, Derrick. Can you tell me exactly why investors around the world are increasingly considering ex China mandates when looking at their emerging market equity allocation?

Derrick: Some are clearly looking to reduce their overall exposure to China, while others, I think, are seeking to maybe fine tune their exposure, maybe through a dedicated China mandate. From our perspective, I think an EM ex China mandate can benefit both sets of investors. I see the emergence of a standalone China and ex China mandates as part of the kind of natural evolution of the market that’s grown in size and importance over the last 20 years, much like, say, Asia ex Japan mandates evolved a generation ago.

Joseph: Can you now tell our listeners how different a portfolio’s output looks in practice once China is removed from an emerging market equity allocation?

Derrick: There are really important risk and return considerations. First, given the recent underperformance of Chinese equities, some investors might view an EM ex China portfolio as removing a weak spot in the EM investment case. But the historical track record really tells a different story. The MSCI Emerging Markets ex China Index has outperformed the broader EM index in just 4 of the last 10 years, although 3 of those have been in the last 5 years. If we look a little longer term since 2001, the performance between EM ex China and the broader EM index has been fairly neck and neck with the EM ex China benchmark, with the EM index outperforming China by about 27 basis points per year. So, it’s been pretty neck and neck. Also, volatility of the EM ex China universe has been slightly higher over the last 10 years, although the relationship has actually reversed recently and the broader EM index has been a little more volatile. From a diversification standpoint, China offers a very low correlation to most developed benchmarks. I think investors will need to make a forward assessment of the future performance of Chinese equities, as well as the benefits of splitting out China as a separate mandate or indeed removing it altogether. And investors need to assess the risks and benefits of Chinese equity exposure.

Joseph: One of the things I’ve heard from the consultant community, which is the client base I cover here at Allspring, is that some managers who have already built EM ex China strategies have potentially not thought deeply enough about the implications or, frankly, the importance of portfolio construction. Can you discuss how your team, Derrick, has thought about the key issue of portfolio construction when looking at ex China emerging market equity allocations?

Derrick: It is a different universe. Country and sector exposure changes meaningfully once China is excluded. Take China out and your top three countries in the EM ex China universe are Taiwan, India, and Korea. So, Asia still dominates. And then from a sector standpoint, we see an increase in financials and information technology while the very important consumer discretionary and communication services sectors fall sharply. So, this raises the question, do we want to look for sector exposure elsewhere in EM ex China or lean into the advantages of the existing EM ex China construction in terms of consumer staples, in terms of financials, etc.? And I think it goes beyond sector considerations. Another big concern we had was currency exposure. While the Chinese currency has been on a broad downtrend versus the dollar in the last several years, it is still a managed currency. It is still less volatile versus the dollar than other emerging market currencies. So, without China, emerging market sensitivity to the dollar would change. Now, this is not a bad thing, per se, but it needs to be considered. And then, finally, how do we look at tracking error? So, simply cutting off China from an existing emerging market portfolio removes a lot of positions and inherently limits the diversification benefits of a broad EM portfolio. Are we comfortable with higher tracking error? Or do we need to work with our risk management teams to manage that volatility?

Joseph: I want to touch on three of the economies you mentioned there. I’m talking Taiwan, India, and Korea. So, clearly these economies become far more dominant exposures once China is excluded. So, out of those three economies, I’m going to pick one here. Let’s start with India. Can you talk me through your team’s view right now on the Indian opportunity right now?

Derrick: India has seen massive improvements in things like infrastructure. The tax and regulatory environment have been streamlined. And the government’s really put in place a range of incentives to attract foreign investment. So, it’s a different and more attractive destination for investment than it was in the past. But I do want to caution investors. I think there’s often this sense that, hey, India is the next China. India is not the next China. It’s the next India. And we need to be very clear that it is a unique market with its own opportunities, and certainly, its own challenges, going forward.

Joseph: We’re now going to jump on, Derrick, toward Taiwan. It might surprise listeners to know that Taiwan is actually the largest exposure within an EM ex China benchmark. What is the residual China risk from investing in Taiwan?

Derrick: I think we need to be very clear-headed about the risks of, in particular, China attempting to reintegrate Taiwan and what that might mean both economically and geopolitically. An EM ex China mandate would not completely insulate investors from this risk. I will say, though, that should there be a conflict between China and the West over Taiwan, the ramifications would be much more far-reaching. Western companies are also inexorably tied to China, both as a manufacturing base and as an end market. The big difference, I think, if we look at the issue from an investment standpoint, is that Chinese companies and emerging market companies pretty much discount this risk more fully than those in the developed markets.

Joseph: So, jumping around the EM world even further, let’s now hit on Latin America, LATAM. So, Derrick, can you briefly touch on the ways that an ex China mandate potentially affects your thinking around LATAM and your outlook on LATAM in general?

Derrick: Sure. The long-term Latin America remains pretty exciting. Mexico, for instance, has been one of the key beneficiaries of the nearshoring or friend-shoring movement. We are seeing multinationals moving supply chains closer to key end markets and Mexico has been a real beneficiary of this. Brazil, of course, a key commodity exporter, is likely to benefit from the green energy transition, as many of its raw materials are used in green infrastructure and will also be a major player in the emerging South American market for consumer goods. One key consideration, though, is that Latin America is particularly sensitive to movements in the dollar. A weaker dollar is very positive for countries like Brazil and Chile, etc. So, if you believe the dollar has peaked, this sort of, quote, short-dollar positioning should be a tailwind over the next several years.

Joseph: Now, we’re going to switch gears to ESG (environmental, social, and governance) and climate implications. Simple question for you, Derrick. Do the ESG and carbon footprint metrics of a portfolio change once China is excluded from an emerging market portfolio?

Derrick: So, the message is a little mixed regarding ESG. So, indeed, the EM ex China universe is more carbon intensive, which shouldn’t be surprising given that China is a net energy importer and some of the large commodity exporters would gain weight in the EM ex China universe. However, EM ex China rates slightly better on other ESG metrics, based on both MSCI and Sustainalytics scores. We need to remember, as well, from a carbon standpoint that China is indeed on the forefront of developing green energy technologies from electric vehicles to solar to wind. So, we do remove that opportunity when we look at the EM ex China universe. That being said, as I mentioned, EM ex China scores higher on both social and governance issues. It also has a lower percentage of UN Global Compact violators, although I think there is some nuance around that issue. And, finally, I think we believe that engagement and assessment is a far more effective tool for approaching ESG considerations than simply focusing on one or two metrics or scores from some of these research providers. In my view, there’s no reason to believe that an EM ex China portfolio should be harder to manage in an ESG-sensitive manner than a broad EM mandate.

Joseph: Thanks for those sustainable insights, Derrick. OK, we’re nearly at the close, but before I let you go, Derrick, I want you to wrap up with your long-term prognosis for emerging market equity investing. So, yup, you guessed it, Derrick. It’s crystal ball time. Clients used to invest broadly in emerging markets with China being the centerpiece of that broad allocation. And clearly for many, this remains the chosen way to access the EM opportunity. As audience members have heard today or at least I hope they have, interest in EM ex China mandates is picking up. And with all this backdrop, Derrick, how do you envisage investors thinking about their emerging market equity allocation 10 years from now? And I fully appreciate this is a very tough question.

Derrick: Well, look, I think despite the shifts we’ve seen and despite the concerns of China, I think China will almost certainly continue to grow and become a more important player on the world stage over the coming years. China’s growth will definitely normalize over the next decades, but its markets will probably also become deeper and more diversified. So, I think it will still make a lot of sense for investors to include China as part of a broad EM mandate, but some may wish to allocate more tactically with single country exposure for China. Others may find the opportunity in emerging markets outside of China more interesting. So, an EM ex China mandate would allow both types of investors to express their unique long-term views in a more, say, targeted manner. The Intrinsic Emerging Markets Equity team is generally constructive on the long-term opportunities in China. However, I think investors will ultimately have to decide the most effective way to access those opportunities.

Joseph: Great. Fantastic insights once more, Derrick. And Derrick, all there is for me to say is I really appreciate you joining us today On the Trading Desk®.

Derrick: Always a pleasure. Thanks for having me.

Joseph: And we look forward to certainly inviting you back On the Trading Desk®, Derrick. I think you’ve teed yourself up for a couple more podcasts going forward. So, look forward to those. And we look forward to keeping our audience members updated on all the key market themes and topics within emerging markets. Thanks to all our listeners. You’ve been On the Trading Desk®.

Announcer: Visit allspringglobal.com to receive more market insights and investment perspectives from Allspring Global Investments. To hear the latest from our thought leaders on the ever-changing investment landscape, you can subscribe to the program on Apple Podcasts, Spotify, or wherever you get your podcasts. Thank you for listening and joining us on the road to investing elevated.


Disclosure: 100 basis points equals 1.00%. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. The MSCI Emerging Markets ex China Index captures large and mid cap representation across 23 of the 24 Emerging Markets (EM) countries* excluding China. With 666 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. You cannot invest directly in an index. The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure equity market performance of emerging markets. You cannot invest directly in an index.


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