The trusts that could benefit from China's isolation

There are opportunities aplenty in emerging markets, argue the speakers at a Kepler conference.

India, Indonesia, Vietnam, South Korea and even Taiwan all stand to benefit as the world adjusts to a new relationship with an increasingly isolated China, according to the fund managers who spoke at our emerging markets-focused conference last week.

Any hopes for a return to galloping growth from China itself were dashed, however, by the panel which was united in its belief that – even were geopolitical issues to subside – the world’s second-largest economy is only at the start of what will be a long-term structural decline.

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Speaking to a live audience of wealth managers at Somerset House in London, and streaming to private investors up and down the country, Ed Butchart, chief investment officer of the emerging markets team at Kepler Partners, said that for China, the slowdown continues from here.

Kepler CIO

“Emerging markets are a biblical asset class. You get these very prolonged periods of feast and then famine, and then feast again. The 1970s were a very good decade for emerging markets-like assets, but then the 1980s were very nasty for Latin America. Further back in time, the 1930s were a decade when emerging markets significantly outperformed developed markets, but then in the 1940s, we saw some of them on the losing side in wars or overthrowing capitalism completely.

“Right the way back into the 19th century, we see these periods where global capital is piling into peripheral parts of the world economy, followed by prolonged bust. Pronounced swings in relative performance are an enduring characteristic and we can see that long-lived investment cycles allied to China have influenced the performance of emerging markets for the last 20 years.

“The boom that emerging markets experienced in the 2000s was very much associated with an acceleration in the rate of growth in China, which joined the WTO in 2001.

“From about 2010, there has been a structural slowing of China’s growth. Exports have slowed, surplus rural labour, which was being transferred to the manufacturing sector, began to run dry and the hangover from the credit surge continues to act as a depressant, and our view is very much that China’s structural growth slowdown continues from here.”

Instead, Ed sees growth coming from countries where credit to GDP ratios are low.

“There are some countries where this plain-vanilla classic emerging markets story has yet to play out, and some of them overlap with where high growth rates are to be found.”

Indonesia, India and Mexico are all on Ed’s winners list, with household consumption and banking stocks in these countries particularly attractive.

“Domestic investment opportunities in countries with the capacity to grow rapidly are, in our view, the secular investment opportunity for emerging markets.”

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Schroder Asian Total Return

Schroder Asian Total Return (LSE:ATR) fund manager Robin Parbrook struck a similar tone, explaining his significant underweight towards China in the trust, which aims to deliver long-term growth from a focused portfolio of Asian equities, with downside protection from a short book designed to eliminate market noise.

Robin and co-manager King Fuei Lee believe the market is expecting too much from China’s reopening and that share prices in those stocks set to benefit have gone too far. They also don’t believe the internet names will be the winners from this, so have stayed away. This has given the portfolio a different exposure compared to many peers in the sector.

“A lot of people ask me if I’m worried by the fact that we have a large underweight toward China in the portfolio and the answer is “no, I am not worried at all”. One thing I do know is that over five years, $220 billion (£174 billion) has gone into Chinese equities. Versus five or 10 years ago, investors have a huge amount more money in China than they did.

“If you take a step back and ask yourself ‘would you have more money in China versus five years ago?’ – knowing what we know today about China, about geopolitics, about President Xi and friendships without limits? No, you wouldn’t of course.”

China’s overpowering weight in the underlying indices is, Robin says, a problem for those trying to make sense of the region.

“The problem is MSCI has been ramping up the Chinese weightings; there’s been a lot of equity issuance, so even though China has been the worst-performing stock market in Asia, its weighting in my benchmark has gone up substantially, while the best-performing country in my asset class – Australia – has actually seen its weighting go down. This is why we need to get away from thinking about indices.”

Like Ed, Robin sees better prospects, in particular, for economies where credit penetration remains low. Like Ed, Robin says banks in Indonesia, India and the Philippines are all attractive, as beneficiaries of the growing ‘financialisation’ of these countries. He warns, however, that enthusiasm for India has left stocks in the subcontinent somewhat frothy.

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Vietnam Enterprise Investments

Dominic Scriven, founder of Dragon Capital, which is the largest foreign investor in the Vietnamese stock market, took the stage next. He expounded on the prospects for the country, which Dragon’s investment trust – Vietnam Enterprise (LSE:VEIL)– is focused on.

VEIL has generated extremely attractive returns over the long run. Returns have been well ahead of the benchmark Vietnamese index, as the Dragon team, led by Dien Vu Huu, have generated significant levels of alpha. However, VEIL took losses last year as Vietnam retrenched in the face of difficult macro conditions and some local political controversies.

Our analysts think Vietnam is an exciting long-term growth market. The country is experiencing rapid GDP growth as it urbanises, attracts overseas’ investment and steadily opens up its stock market and economy to foreign investors. Clearly it also brings risks, with political and economic volatility expressed in volatile stock market returns.

On that long-term view, the cheapness of the market after a difficult 2022 adds to the attractions, with VEIL’s double-digit discount potentially adding to the return potential. Our analysts also argue that Vietnam looks more attractive given the increased political tensions between the US and China. Vietnam can maintain links with both actors and remains a key locus for manufacturing for global blue chips.

Dominic said Vietnam’s increasing prominence as a low-cost, highly skilled alternative to China – with China’s increasing isolation as a tailwind, and a supportive environment in Vietnam itself driven by huge government spending on infrastructure – would likely continue to be a significant driver of returns. He warned, however, that volatility would continue to be a factor affecting anyone investing in the region.

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Mobius Investment Trust

Carlos Hardenberg, who founded Mobius Capital Partners alongside emerging markets legend Mark Mobius and manages Mobius Investment Trust (LSE:MMIT), was our final speaker on the day.

The trust invests in small and mid-cap companies across the emerging and frontier-market universes, aiming to generate long-term capital growth and income returns from a highly concentrated portfolio of 20 to 30 stocks.

The managers have a bias towards quality growth stocks, which they aim to buy when they are trading at a discount to their intrinsic value, and then hold for the long term.

Like Robin, Carlos said the team have little interest in the benchmark. Instead, they focus on identifying companies which are profitable, with solid capital structures and, ideally, little or no debt.

The trust has a very significant underweight to China, which makes up 7.4% of the portfolio versus 17.6% of the trust’s benchmark, and instead has chunky bets on Taiwan (26.1% vs 15.9%), India (18.4% vs 13.4%) and South Korea (14.8% vs 10.7%), as well as a number of frontier markets, including Vietnam.

Carlos cited India as an example of an economy in the ascendant: “The atmosphere in India is amazing. I have never experienced it in this way before. When you talk to entrepreneurs there, they are all so optimistic there, and I’ve also never seen such substantial investment being made in India; it’s really happening."

Setting China aside, Carlos highlighted the current discount on emerging markets’ equities across the board – when compared with the valuations of developed market counterparts – which stands at a record level, saying: “Estimated earnings growth shows the MSCI Emerging Markets Index is expected to grow around 12% over the next three to five years, compared to the FTSE 100’s 3%, which is a substantial recovery in earnings growth, helped by about four billion Asian people who are beginning again to consume in a more normalised way.

“The discount on emerging markets makes it an absolute paradise. This is a good time to buy quality assets, when there is abundant pessimism flooding the street, and I think there will be a time when we look back and say “gosh, this was a fantastic opportunity – the market just got too negative”.”

Click here to watch Carlos’ presentation

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