Sao Paulo's stock exchange (Bovespa) headquarters. Photo: Nurphoto / Cris Faga

Except for China, which gained more than 20% this year on the MSCI index, emerging market stocks have disappointed investors. That’s remarkable, considering that the S&P/Goldman Sachs Commodity Index rose by 17.5% year to date, and emerging markets earn a disproportionate share of their income from commodity exports.

Some of the biggest commodity exporters, for example Brazil, were among the worst performers; even Peru, which is a pure commodity play, gained a bit over 10%, far less than the commodity index.

The trouble is that you can’t buy a national economy. You can only buy the stocks that are offered for sale in that country’s equity market. For the most part, emerging market stock markets are heavily skewed towards banks (25% of the index), phone companies (12% of the MSCI index) and consumer companies (13%).

Emerging market banks are a soup that should be eaten but not stirred. Emerging market telephone companies (excluding East Asia) are inefficient and backward. Retail and other consumer discretionary companies are rapacious. 14% of the MSCI Index (ETF Ticker EEM) is in information technology, domiciled almost entirely in China, Taiwan and Korea.

In Brazil, the largest emerging equity market outside of Asia, financials are nearly 40% of the index, and information technology is barely over 2%. Materials companies comprise 16% of the Brazilian index, energy 13%, and consumer companies 17%. The new Brazilian government has inherited a legacy of official corruption and a pension funding problem that threatens to bankrupt the country, and these problems weigh on the country’s stock market. But the fact remains that two-fifths of the stock market is financials, the most opaque and error-prone sector of the market.

There are special circumstances weighing on the high-tech economies of Taiwan and South Korea, to be sure: the US-China tariff war has disrupted the global supply chain and frozen a large number of transactions. But in most of the emerging world, the trouble isn’t lack of economic growth or future economic prospects, but rather the composition of the stock market.

The future bodes well for emerging market economies, but not necessarily for their most prominent companies. China’s ascendancy as an investor and technology provider in the Global South will displace many existing firms.

As Daniela Guzman wrote in a Bloomberg report earlier this year:

“As America recedes into the background, Chinese foreign direct investment in Latin America and the Caribbean has skyrocketed over the last ten years, according to a 2018 report by the Economic Commission for Latin America and the Caribbean. China dropped close to $90 billion in the region between 2005 and 2016. With a growing emphasis on telecommunications, Chinese investment in emerging technology is increasingly the primary fuel behind Latin America’s tech boom.” One South American entrepreneur told Guzman, “When you go to China, you see what’s going to happen in Latin America in five more years. Today, we look at China. We look at Meituan, at Alibaba and Tencent, to see what we can do in the future.”

China’s telecommunications, e-commerce and e-finance companies may become the beneficiaries of economic growth in other emerging markets, while new technologies and business methods sideline established companies.

The sharp divergence between Chinese stocks and the EM index points to a change in the character of emerging equity markets in which global Asian companies will replace much of the inefficient deadwood in national indices.

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