India and China are the cornerstones of the emerging markets equity universe, but the outlook for these investment markets may be very different, according to the director at emerging markets at FSSA Investment Managers.
Richard Jones said China had embraced a profoundly competitive capitalist system, “where competition is intense and where any firm that has a major advantage finds that advantage competed away in the market place".
This has been positive for economic growth and seen China advance “in the blink of an eye” in terms of economic development”, he said, but it has meant investment returns have been meagre, particularly if one wishes to own companies that are consistent with the “quality factor, with high returns on equity".
Jones said it could be hard to identify Chinese companies where the returns were sustainable.
He contrasted China with India in this regard, saying that while the Indian stock market had performed strongly, the economy was replete with "a lot of rigidities", including regional variations in taxes.
This is arguably negative for economic development but meant some companies could achieve very high returns on equity.
With this in mind he regards Indian equities, despite their recent share price appreciation, as being “not cheap but more like fairly valued” in the current climate.
He said one of the challenges he faces as an emerging markets investor was political risk, though in China he feels the bigger issue may be the fact the country is now in the “middle income trap”.
This is a phenomena whereby countries rapidly grow their economies through becoming low cost manufacturers, but to remain competitive, they maintain interest rates at a level lower than is justified by the strength of the economy.
This can lead to inflation, and quite often to excessive lending which leads to a boom in house prices, which then proves unsustainable and leads to a crash.
Jones feels these conditions may have existed in China, and notes that country’s stock market has been dominated by property companies and banks, rather than many of the lower cost manufacturers that drove the economic growth.
Dominic Scriven, the founder of Dragon Capital who runs a Vietnam-focused investment trust and open-ended fund, says the first part of that equation, China deriving material amounts of growth from being the low cost manufacturer, is already ebbing away, with companies relocating that to Vietnam.
Jones agreed manufacturing was moving out of China, and believes the long-term pattern will be that goods made by Chinese companies for export will be made outside of China for geo-political reasons, while those made for domestic consumption will continue to be made in China.
He said the principle way countries can exit the fixed income trap is by moving to becoming producers of high value goods and services, alongside becoming more of a consumer economy.
david.thorpe@ft.com
