Investing in emerging market stocks is considered riskier than buying U.S. stocks for many reasons. For instance, adverse foreign exchange movements could wipe out the entire value of international investments, and developing countries in particular are prone to credit default risk as well.
Because of this increased uncertainty, investors seek higher returns from these investments to justify bearing the additional risk. Since global markets bottomed on March 23, the S&P 500 index has gained a staggering 56% through Nov. 6, and the iShares MSCI Emerging Markets ETF (EEM, Financial) has also replicated this movement by appreciating 56%.
There is nothing between the two classes of assets for now, but a closer evaluation of macroeconomic prospects reveals the possibility of emerging markets outperforming U.S. stocks in the coming years. Investors, arguably, are not late to consider diversifying into this lucrative asset class.
China is bouncing back faster than many advanced economies
The American economy entered a recession earlier this year as business activities came to a standstill in the latter half of the first quarter. Things were no different for countries in many other regions as well. Arguably, the current economic downturn is one of the worst the modern world has ever seen.
However, even though China was the first country to feel the wrath of the Covid-19 pandemic, the recovery so far has been stellar.
The International Monetary Fund projects the world economy to contract by more than 5% in 2020, but to the surprise of many investors, China is expected to report economic growth of close to 2% this year, even though the majority of advanced and developing countries will remain in the red for the year.
Source: The International Monetary Fund
In 2021, the IMF expects China's economy to grow at over 8%, which would lift the country as the fastest growing nation in the world once again, a title the country lost to the likes of India in recent years. The primary reason behind China's expected dominance from an economic growth front is the manner in which the country has curtailed the spread of the deadly pandemic. With a very low risk of local transmissions, China is once again focused on achieving new economic milestones whereas many other nations are still struggling to cope with the new reality due to their insufficient attempts to control the pandemic.
Consumer spending in China is making a gradual comeback as well, which is a promising sign. Companies such as Nike (NKE, Financial), Tesla (TSLA, Financial), Starbucks (SBUX, Financial) and McDonald's (MCD, Financial) reported stellar revenue growth in China even though their sales in other parts of the world remained sluggish in the first half this year. This is an early signal of a rebound in both retail and luxury sales in the country.
The competitive advantages of China are likely to help the economy propel in the coming years. One way investors who are unfamiliar with Chinese companies can gain exposure to this projected growth is by investing in an exchange-traded fund with a focus on Chinese companies.
The case for iShares Emerging Markets fund
There are many ETFs and American Depository Receipts that provide direct exposure to China, but the iShares Emerging Markets fund stands out to me because of the diversification benefits associated with this financial instrument.
As illustrated below, the fund has invested in equity securities of companies domiciled in Taiwan, South Korea, India and Brazil as well, and all these countries are expected to grow faster than advanced economies in the next few years.
Portfolio breakdown by country (%)
Source: BlackRock
Even though a direct equity investment in a Chinese company could deliver higher returns than this fund, the diversification benefits will help reduce the total risk of a portfolio. Besides, countries such as India and Brazil are emerging as alternatives to China from a supply-side perspective, and the fund provides a balanced exposure to all these attractive nations through a single investment.
Gurus that believe in China
Ray Dalio (Trades, Portfolio) is among the many legendary investors who believe in China's growth story and its ability to become the largest economy in the world within the next few decades. In an opinion piece published in The Financial Times in October, the guru wrote:
"Prejudice and bias always blind people to opportunity. Since 1984, China's per capita income has risen more than 30 times, life expectancy has increased by a decade, and poverty rates have fallen nearly to zero. China's fundamentals are strong, its assets relatively attractively priced. These currently account for 3% or less of foreign portfolio holdings whereas a neutral weighting would be closer to 15%."
Dalio went on to suggest that many investors are missing out on a golden opportunity that could deliver multi-bagger returns because of a persistent anti-China bias, which, according to the guru, should not come in between an investor and a good investment.
In addition to Dalio, Howard Marks (Trades, Portfolio) of Oaktree Capital and Blackstone's Stephen Schwartzman have also spoken positively about this East Asian nation in the recent past and revealed investments in the region.
Takeaway
To achieve long-term investing success, one needs to identify macroeconomic trends as early as possible. This is a tried and tested recipe for generating alpha returns.
The global economy has gone through a lot in the last 10 months, and China seems to be coming out ahead on many fronts. The country is poised to deliver unmatched returns in the coming years, possibly decades, as this Asian nation transitions into an economic superpower. Ignoring this reality could lead to meager returns from an investment portfolio, in my view. Making investment decisions based on sentimental viewpoints is not a winning strategy - the key is to base decisions on fundamental data.
Sharing his views about the U.S. election and capital markets, Aberdeen Standard Investments' head of Asian sovereign debt department Kenneth Akintewe told CNBC:
"For Asia, it's very important to remember that the election is actually not the most important thing going on. The data is one of the most important things going on. You're seeing recovery in exports, production, the indices – not just manufacturing but in places like China and India the services sector as well. We've already seen better economic data than what we previously anticipated, so growth momentum going into next year is actually looking pretty good."
There is hard data to back up the claim that China and other emerging markets are recovering faster than the rest of the world, and investors are not too late to act on this information. Capital market performance is at an inflection point where developing regions are beginning to take over, and stellar returns can be expected from this asset class in the next decade.
Disclosure: The author is long iShares Emerging Markets ETF.
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