Emerging markets ETFs or investment trusts: Navigating rate cuts, China risks, and market opportunities

The Federal Reserve’s September rate cut sent US and emerging markets soaring, with the iShares MSCI Emerging Markets ETF benefiting from a liquidity boost. Yet, China—accounting for over a quarter of the index—casts uncertainty, given its economic struggles and regulatory headwinds. London-listed investment companies offer alternatives, letting investors adjust their China exposure.

By Frank Buhagiar

18 September 2024 saw the Federal Reserve finally cut US interest rates, lowering the key lending rate target by 50-basis points to the 4.75%-5% range. US markets reacted positively to the cut. The yellow scribble on the graph below highlights the immediate response to the news from the S&P500 (dark blue line), the Nasdaq (pink line) and the Dow Jones Industrial Average (light blue line) – all three indices enjoying a sharp spike and, for the most part, holding on to the gains made.

US markets, however, not the only ones to benefit. Emerging markets too welcomed the news. As the graph below shows, the iShares MSCI Emerging Markets ETF enjoyed a bounce on the day of the rate cut:

And like US markets, the ETF, which tracks the MSCI Emerging Markets Index held on to the gains made. To be fair, not much new here – emerging markets generally react well to Fed rate cuts. Reasons include the lower yields on US assets make those of other asset classes more attractive;while lower US rates reduce the cost of borrowing in US dollars, thereby easing liquidity conditions. According to the National Bureau of Research (NEBR), “when the Federal Reserve lowers US interest rates, there is an increase in cross-border loan volumes by global banks, particularly with regard to emerging market economies.” The NEBR’s paper ‘US Monetary Policy and Emerging Market Credit Cycles’ looked at the 1980-2015 period and found that, even after accounting for differences in GDP growth, inflation, and forecast future economic performance, “a 4 percentage point cut in the Federal Reserve’s target interest rate (a typical decrease during an easing cycle) increased loan volumes in emerging markets by 32 percent relative to the volumes in developed markets.”

And increased capital inflows tend to spur economic growth – no wonder the iShares ETF reacted well to the 18 September US rate reduction. What’s more, with more rate cuts expected in the US, it would seem emerging markets are well placed. But before investors rush to write out their buy dockets for the iShares MSCI Emerging Market ETF, there’s an elephant in the room. And, it’s a big one. China.

As at end of September, the country accounted for over a quarter of the MSCI Emerging Markets Index, easily the biggest contributor. But Chinese markets have had a tough time. According to JPMorgan Emerging Markets’ (JMG) Half-year Report earlier this year, “For China, it (2023) was another annus horribilis, with sustained falls in share prices leaving the market down 16% in sterling terms, with declines continuing throughout the year.” So, even though other emerging markets had decent 2023s, returning in aggregate 14% in sterling terms over the course of the year “given China’s significance in the asset class, the two combined to produce only a modest outcome for the overall emerging market index: the year as a whole saw a return of 4.4% for the benchmark index.” How China fares has a big impact on how emerging markets, as an asset class, fare.

As for why China had a poor year, JMG cites, a slowing economy and ongoing regulatory uncertainty. Ashoka WhiteOak Emerging Markets (AWEM) Investment Manager’s Report in June sums it up neatly “China’s economy has been grappling with persistent deflationary pressures, exacerbated by its property crisis and stubbornly weak domestic demand. Over the past three years, policy uncertainty, muted fiscal stimulus and certain regulatory interventions have weighed on investor confidence. US-China relations, since the trade tensions began in 2018, have also been one of the factors constraining equity returns in China.” Despite this, AWEM’s investment managers write “While we are not influenced by strong ‘top-down’ macroeconomic views on China, we do expect domestic sentiment to improve gradually”.

Not sure about how AWEM defines the word “gradually” but fast forward just a few months and sentiment towards China got a major boost after the central bank cut rates and the authorities announced steps to boost growth as part of what Winterflood describes a “stimulus wave”.

Things potentially looking up for China; throw in US interest cuts and it could be all systems go for emerging markets funds. Time will tell. In the meantime, the worry remains that the recent improvement in sentiment towards Chinese stock markets proves to be fleeting – after the initial burst of excitement, Chinese markets once more found themselves under pressure. At the same time, geopolitical/global trade risks remain, especially with a US election just days away. On this broker JPMorgan is reminded that back in 2016, “when Donald Trump won the US presidential election, EM assets had a meaningful selloff, down 10% relative to DM over the following two months. If Trump wins, then we believe EM will be a laggard, at least initially. On the other side, if Kamala Harris wins, and we have a divided Congress, then EM could start to perform better more sustainably.”

With a quarter weighting in China, for some, plumbing for an MSCI Emerging Market ETF might just be too much of a rollercoaster ride to stomach, particularly, as JMG’s Half-year Report noted “The drag on the entire asset class from China threatens to obscure the fact that other emerging markets have come through a challenging few years in relatively good economic shape.” The report cites lower levels of fiscal support from emerging market governments during the pandemic compared to developed countries, which has enabled them to avoid ramping-up sovereign debt; and when inflation reared its head, emerging market central banks in the main acted decisively so that they now have scope to lower interest rates and support domestic demand. As JMG notes, “That is not a bad backdrop for domestic business profits and for growth.”

So, with question marks hanging over China, wouldn’t it be handy if there was a way to invest in emerging markets without having that 25%+ exposure to the country the ETF has? Step up London’s investment companies. No shortage of options in the Association of Investment Companies (AIC) Global Emerging Markets sector, home to no less than 11 funds. Unlike their equivalent ETFs, these funds are actively managed and so can underweight/overweight particular countries within the emerging market universe, including China.

Because of this, investors have a range of funds to choose from to match their own views on investing in China. From Templeton Emerging Markets at one end of the spectrum with a near inline 23.1% exposure to China as at 31 August 2024 to Mobius at the other end of the scale with just a 2.5% weighting. Three other funds fall in between. JMG, for example, had 16.8% of total assets invested in China as at 31 July 2024. AWEM, even more underweight with just 10.5% of total assets invested in China as at 31 August 2024. And then there’s Fidelity Emerging Markets with 6.2% of total assets in China.

There are also funds with no exposure to China whatsoever and, unless there’s a change in investment policy, will most likely never do so. These include BlackRock Frontiers, which only invests in frontier markets so China not even on the radar.

Same is true of Baring Emerging Markets EMEA Opportunities (BEMO), albeit for geographic reasons. In a recent interview with Doceo, portfolio manager Adnan Al-Eraby notes, “When most investors talk about emerging markets, they’re referring to the large component of the index which is Asia. Asia has a large population, naturally has the largest economies and has several large markets that dominate the index, which is China, India, South Korea and Taiwan.” But there are other regions too, such as emerging EMEA (Europe, Middle East, and Africa) markets. As the name suggests, this is where BEMO invests. Among the fund’s top country weightings are Saudi Arabia, South Africa, Poland and Greece. Because of this “The trust offers global investors and asset allocators the opportunity to invest in a portfolio of companies that are often overlooked by large institutional investors that offer diversification benefits”.

For those investors looking to up their emerging markets exposure, London’s investment company space offers a range of options to suit their own views, not just on individual countries such as China, but also on particular regions such as Asia or EMEA.

What’s more, after a tricky period which, according to JPMorgan, has seen Emerging Markets underperform Developed Markets by around 2% year-to-date and 30%+ relative over the last three years, investment company share prices across the sector are trading at an average discount of 12.5%. That could provide a kicker to returns should emerging markets, well, emerge from the shadows of their larger developed peers.