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Unpredictable, not uninvestable: emerging markets no lost Paradice

As Paradice’s emerging market equities strategy hits its three-year anniversary, the outlook for the asset class has never been more uncertain. But the local institutional appetite is voracious.

From Covid to Common Prosperity, emerging markets have been roiled by upheaval in the last two years. And Russia’s invasion of Ukraine sent global markets into the first of several death spirals that have been occurring more often since the start of the year.

A question that has lurked in the background of the emerging markets since Russia’s invasion has been whether China will embark on similar adventurism in Taiwan, with the same disastrous consequences to follow. But Michael Roberge and Edward Su, co-portfolio managers for Paradice’s emerging markets strategy, are optimistic that further upheaval will be avoided.

“We’re not of the belief at this juncture that China is going down the same path as Russia in terms of wanting to invade Taiwan,” Su said. “China is nowhere near self-sufficient enough to be able to do that and it would really put their people at quite a big risk. We don’t believe it’s in President Xi’s best interests.”

Of course, the same applied to Vladimir Putin when he made the fateful decision to commit his army to an invasion that has now seen a third of it destroyed. The US recently ran highly-public tests for a new kind of ship killer bomb, and, per the New York Times, is engaged in a rethink of how Taiwan can best arm itself to repel an invasion. Su doesn’t believe an invasion is an outside possibility – it might happen in another decade or so – but notes that invading Taiwan would be even harder than invading Ukraine, given matters of geography and economics.

“Russia had been preparing for this for quite a while,” Su said. “They’d been trying to become more self-sufficient and build up their reserves. I think Putin was given bad intelligence by his people; they were afraid to tell him the truth on some things and let him believe it would be an easy thing to accomplish.”

“What they’ve seen is the complete opposite. And I think because of how much the West saw Ukraine being willing to put up a fight, I think that then got everybody focused on putting through some pretty tough sanctions they would never have considered before.”

Still, Su notes that China under Xi Jingping has grown more ideological and less pragmatic. Previous administrations would rethink a policy if it had unintended consequences or became unpopular. That’s no longer the case. Su believes that the persistence of China’s Covid Zero strategy is mostly to do with the imminent 20th National Congress of the Chinese Communist Party, to be held later this year, at which Xi is expected to seek a third term as general secretary of the party – exceeding what has previously been a two-year limit – or take on the previously abolished position of chairman, last held by Hu Yaobang in 1982.

“For the last year and a half, China has prided itself on being the best at handling Covid. They’ve thought that their strategy has been what worked and they’ve poo-pooed Western vaccines and the Western way of doing things,” Su said. “To all of a sudden say “Zero Covid doesn’t work anymore” is admitting that Xi is wrong. It’s a pride thing and a political thing.”

China’s regulatory upheaval has been a large detractor for a strategy focused on domestic demand within the emerging markets. The two PMs are now trying to spread their risk across businesses they believe are out of the crosshairs of China’s regulators.

“The importance of diversification has been a lesson delivered over the last couple of years,” Roberge said. “In these low prediction environments and regular black swan type events, it’s as important as ever.”

The strategy was launched in 2019 with the support of three large Australian institutional investors.
Paradice manages $600 million emerging market equities and believes that could be scaled up significantly, without nominating a particular capacity. The San Francisco-based Roberge and Su are Down Under to meet existing clients and shop their track record to a number of undisclosed larger funds alongside head of institutional distribution Stephen Bramley.

That endeavour might prove a litmus test for local institutional appetite for emerging markets. A recent State Street survey of a number of large pension and sovereign wealth funds found the largest level of emerging markets selling observed over the previous five years in a flight to politically-stable developed markets. However, anecdotal evidence gleaned from the horde of other managers now descending on Sydney suggests that the local appetite for EM strategies is substantially higher now than several years ago (though some large Australian funds are less willing to discuss their China exposure post-Ukraine).

“We’re not in the China is uninvestable camp,” Roberge said. “But what you’re seeing is a lot of marginal risk management and paring back exposure and finding homes for it elsewhere in the emerging markets. The problem is that many of the smaller emerging markets don’t have the breadth, the depth and the liquidity to absorb the type of flows we’re talking about coming out of China.

Sanctions on Russia have caused significant volatility for commodity markets, with that country accounting for global exports in the order of 10 per cent of petroleum, 20 per cent of natural gas, and 15-20 per cent of wheat (Ukraine also contributed a significant chunk). That’s driving the beginnings of a food crisis in some frontier markets, and food protectionism in countries like India and Indonesia. Protracted high inflation would only add fuel to the fire, with social unrest and uprisings likely to follow. It’s an environment where it seems another black swan could emerge at any time.

“Three years ago, you might have said a pandemic was an underappreciated risk because nobody had ever seen it before,” Su said. “Now we’ve seen it. You might have said war was an underappreciated risk but we have war. One by one over the last three years you’ve seen these six sigma events that nobody had a playbook for now playing out.”

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