China's surprising manufacturing contraction could prompt some trigger-happy investors to pull funds out of emerging markets. Usually, negative data out of the world's second-largest economy has that effect.
The Caixin manufacturing PMI, which focuses on small and midsize firms, came in at 49.6 for May vs. expectations of 50.1, and was down from 50.3 in April. This is the first time in 11 months that this indicator fell under the 50 threshold separating expansion from contraction.
The yuan appreciated despite the gloomy news, with state-owned banks rumored to have been selling dollars to prop up the Chinese currency at the request of the People's Bank of China.
Even though they might be spooked, investors should not sell their emerging markets holdings because of this development. First, the contraction in PMI is minuscule and it is just one month. But more importantly, trade data show that emerging markets are still the place to be in these days of extremely low growth.
A pick-up in global trade early in the year has been driven by surging import demand from emerging markets, which reported stronger activity and are seeing their currencies appreciate, and by corresponding strong exports.
Data from the CPB Netherlands Bureau for Economic Policy Analysis, which publishes a World Trade Monitor, show that emerging markets' imports advanced by 3.5% in the first quarter from the fourth quarter of last year, compared with the 0.5% pace of growth for advanced economies' exports.
By region, Central and Eastern Europe experienced the fastest advance, of 6.8%, which confirms other data that show eye-popping growth in that part of the world. It was followed by Latin America, with 5.4%, and emerging Asia with 3.3%.
A lot of the imports emerging markets take in go into products that ultimately are exported, so the strong performance was mirrored on the other side of the trade ledger.
Exports from emerging markets advanced by 1.9% in the first quarter vs. a 0.4% rise in exports from advanced economies. Again, the star was Central and Eastern Europe, with a 6.6% surge in exports, followed by Latin America with 5.2% and Asia with 1.3%.
The data confirm that growth is much faster in emerging markets than in advanced ones, where valuations are stretched as well, especially in the U.S. stock market. So, should investors just buy securities in the countries that export the most?
Not really. For longer-term investors, it makes sense to look at how sustainable the growth in external trade is for these countries. One way to do so, according to Louis Kuijs, head of Asia economics at Oxford Economics, is to look at how well they master technology, as evidenced by research and development (R&D) and innovation.
"Indeed, this is crucial for avoiding the middle-income trap. However, in reality, the degree to which technology is mastered varies greatly among middle-income countries," Kuijs wrote in recent research.
His research found that China and the Czech Republic are relatively well-placed for further catch-up, as they have moved from relying on imported knowledge to developing their own.
But economies such as Malaysia, Thailand, Mexico and Romania, despite their big, export-oriented manufacturing sectors, do not master technology as well. These countries run the risk of falling into the middle-income trap, when an emerging market cannot advance beyond a middle-income level.
Finally, Latin American countries such as Argentina, Brazil and Chile as well as Saudi Arabia and South Africa also score poorly, suggesting that they are not well-positioned for sustained rapid growth between now and 2026, which is the horizon Kuijs' research examined.
One enigma -- as always -- is Russia. The country scores well on innovation and research but has a weak manufacturing base, which shows it is suffering from the resource curse. Still, this situation means that if oil prices decrease further, at least Russia will have something else to fall back on.
The latest PMI data out of China should not put investors off emerging markets. However, the data should serve as a reminder that putting money in this asset class is a long-term, carefully chosen investment decision.
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