If you have been reading my musings this week, you will be aware that I am not particularly bullish about the immediate future for stocks here in America. Yes, Treasury yields, which have been driving the market for some time, have fallen quite dramatically from their highs, but that is because U.S. economic data is starting to show more of the weakness that one might expect after a period of tightening by the Fed, and that has potentially bad consequences for growth.
I often turn to emerging markets for potential gains when the outlook for the U.S. economy is uncertain or not great, assuming that a damaging global recession looks unlikely, but current circumstances make that a more complicated endeavor than it often is.
Buying a broad emerging market ETF such as the biggest, the iShares MSCI Emerging Market Fund (EEM) is not the answer. This year has been basically flat for EEM, a period when the S&P 500 has shown significant gains. However, as the chart below shows, that neutral performance hides a big divergence in the performance of the two most represented countries in the fund that together make up over 45% of the fund’s holdings, China, and India.
EEM (Main body), EPI (India, blue line) and MCHI (China, green line)
That is in part because of relative economic weakness in China. If that were the only reason it wouldn’t be a problem. The Chinese economy can weather periods of weakness better than most and turn things around faster if need be. There are plenty of downsides to a command economy, but that is an upside of centralized government control. However, this is not just about a cyclical downturn in China. There is another, longer-term factor at play here: Companies based in developed nations are deliberately shifting away from China.
For example, there have been rumors for some time that Apple was looking to move production of parts for its suite of products away from China, and reports coming after yesterday’s market close seem to confirm that. In particular, the stories indicate that they are looking to shift battery production to India. The implications of that seem obvious -- good for India, bad for China -- and this probably isn’t the time to overthink things.
Diversifying the supply chain away from China to some extent makes sense for Apple in the way that a diversified supply chain make sense for all companies. We learned a painful lesson during the pandemic and in its immediate aftermath, that too much dependence on one country for supply can be dangerous. Apple is embarking on a plan to correct that. Their decision to do so is making the news, but you can be sure that they are not alone. Most other companies with a globalized supply chain will be doing the same thing.
Not everyone is favoring India. Taiwan, Korea, and countries like Bangladesh and South Africa will also be beneficiaries of the shift, so while an India-focused ETF like EPI makes sense in some ways, a broader fund like the iShares Emerging Markets Ex-China Fund (EMXC) is the best way to cover all bases:
Over the last couple of decades, as China has allowed a more capitalistic approach to business, the world has become increasingly dependent on that country for supply and manufacturing. There have been problems, though, both political and economic, that come from depending on a country with an autocratic, single party system. The post-pandemic supply disruption was, for many, the last straw. That makes the downturn in China more than just cyclical weakness. So, if you are considering diversifying into emerging markets in anticipation of some weakness in U.S. stocks, something that isn’t exposed to China is a better bet than traditional emerging market funds.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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