While China’s recovery will aid trade and benefit other emerging markets (EMs), at a sector level, local, consumption-driven growth will remain a core theme for many EM economies, according to Franklin Templeton Emerging Markets Equity.
Three things we are thinking about today:
- Golden Week: The first week of October in China is known as national Golden Week. It is a period when workers take time off for travel and entertainment. Investors monitor the holiday to assess household spending trends, as well as sector beneficiaries. Daily trips on China’s railways set a new record of 20.1 million on September 29,1 the first day of the holiday. We are monitoring sales data and company updates in the hotel, airline and property sectors for signs of a change in the current cautious spending trend.
- Higher for longer: The US Federal Reserve’s (Fed) dot plot, a summary of economic projections for interest rates, indicates US rates will be higher for longer. Updates from Asian manufacturers supplying household goods to US retailers indicates demand in the third quarter (Q3) period was better than expected. Nevertheless, the cumulative impact of 11 Fed interest rate increases since March 2022 is eroding US household purchasing power. This creates downside risks for demand and in turn emerging market (EM) exports.
- US dollar strength: The greenback strengthened in the Q3 period, following a weakening trend in the prior two quarters. EMs have historically struggled during periods of US dollar strength due to factors including higher cost of foreign currency debt and tighter liquidity. As there is no uniform EM interest rate trend in the current cycle – Brazil and China are cutting rates while Turkey is raising rates – the historic relationship between the US dollar and emerging markets may not hold as strong. A divergence in performance already occurred in the Q3 period, as domestically focused markets such as India outperformed externally focused ones including Taiwan and South Korea.
Outlook
Economic growth in EMs has shown signs of improvement, but the uncertain global trade environment remains an overhang. Nevertheless, we believe that there are accompanying opportunities.
During the quarter, our portfolio managers observed that the turnout for the first broad-based China-related conferences in nearly four years was stronger than expected, which suggests that investors and corporations are still interested in opportunities in China.
Our meetings with China-based internet companies confirm this. These firms dominate the Top 10 holdings within the MSCI China Index and have expressed their strategy to reinvest earnings for revenue growth, pivoting away from their previous strategy of cost-cutting to preserve earnings.
We believe that improving macroeconomic conditions is supportive of reinvestment, which we view as important for long-term earnings growth. In our view, stimulus spending kickstarted China’s recovery, but corporate reinvestment will be crucial to achieving the country’s long-term growth plan.
While China’s recovery will aid trade and benefit other EMs, at a sector level, we believe that local, consumption-driven growth will remain a core theme for many EM economies.
In Brazil, the government enacted measures to boost families’ disposable income, which helped drive household demand and support the economy. In India, domestic consumption has historically hovered around 50% of contribution to growth.
A combination of favorable demographics – rising income levels, evolving consumption patterns and under-penetration of goods and services – creates significant opportunities across the retail, health care, and entertainment sectors.
In export-driven Taiwan, domestic demand in the second quarter of 2023 rose by 12% year-on-year, a 33-year-high.2 Against a backdrop of weak global demand, we believe the normalization of domestic activities and stabilization in inflation in EMs should support the recovery of domestic demand over the remainder of the year.
Amid varying macroeconomic environments in different economies, bottom-up research remains crucial, in our view. In China, we continue to prefer companies which are less affected by regulatory scrutiny.
We are focused on domestic companies that we believe will benefit from long-term thematic growth drivers, including rising consumption and localization. Outside of China, our focus is on dividend-paying companies with solid balance sheets and strong earnings growth.
What are the Risks?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
There are special risks associated with investments in China, Hong Kong and Taiwan, including less liquidity, expropriation, confiscatory taxation, international trade tensions, nationalization, and exchange control regulations and rapid inflation, all of which can negatively impact the fund. Investments in Taiwan could be adversely affected by its political and economic relationship with China.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
1. Source: China.org.cn. “Travel frenzy to reach new peak in China’s ‘golden week’ holiday period.” October 2, 2023.
2. Source: Bloomberg, as of September 29, 2023.
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