What Investors Need to Know About U.S. Exceptionalism and Market Performance

On this episode of The Long View, Justin Leverenz, the team leader and senior portfolio manager for the emerging-markets equity team at Invesco, talks about global markets, opportunities for investors, and more.

Here are a few excerpts from Leverenz’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Disparities Between Emerging and Developed Markets

Christine Benz: We wanted to dial out a little bit to talk about emerging markets more broadly. Let’s start by talking about the performance disparity between emerging markets and developed, especially U.S. Our U.S. equities index is up 3.0 times over the past 10 years. Emerging markets are up less than 1.5 times over that period. So, we all know the U.S. story, but I’m wondering if you can talk about what has gone wrong with emerging markets during that 10-year stretch?

Justin Leverenz: I would say it’s quite an interesting conversation that could take up our entire podcast. The first and most important thing to point out is that this is very much about U.S. exceptionalism over the last 10 years. And in fact, we’ve written quite extensively about this, but every decade there’s a set of themes that tends to drive global equity markets. And so, the last 10 years, the U.S. S&P, and we’re not even talking about the Nasdaq or the “Magnificent Seven,” returned midteens U.S. dollar returns, whereas as you pointed out, EM [emerging-markets] returns were more than 1,000 basis points of underperformance during this period. If you go back to the decade that preceded this period of U.S. exceptionalism, it was really an emerging-markets decade. You saw the same sort of phenomena. U.S. equity returns were 2% compound over 10 years, and EM outperformed midteens U.S. dollar returns. And so, I think that there are long-term mean-reversion characteristics.

In the last 10 years, I think there were a couple of exceptional circumstances. First, when emerging markets did spectacularly well, let’s say 2002 to 2012, there were considerable excesses that developed in terms of internal imbalances, external imbalances, and frankly, a lot of asset bubbles. And you had a period of five or six years in many of these economies where there was a significant need to repair these imbalances by growing more slowly. You also, of course, had a significant correction in commodity prices after the rise of the China-driven commodity supercycle we saw during the EM decade. And so there was a big transition in the large emerging-markets economies in terms of greater resiliency and slower growth.

In the emerging markets, there was another story, which of course is a more recent story, which is about significant economic challenges that have emerged in China over the last, I would say five or six years, but with increasing speed over the last few years. And in fact, the significant underperformance of Chinese equities has really obfuscated the underlying return profile of emerging-markets equities in total, because of course, the weight of China in the benchmark is so significant. If you go back two years ago, China was 40% of the benchmark weight. Today, it’s still 27%.

If you look at 2022 and 2023, I think they’re quite instructive in two dimensions. The first is EM excluding China has been incredibly resilient. You remember 2022, there was no place to hide as rates were moving up. Fixed income and equities around the world did very, very poorly. EM ex-China actually performed in line with both worldwide equities and also MSCI international equities or the EAFE index. And that’s very rare. I’ve been doing this for 30 years, and that sort of resilience is not to be expected. I think the EM ex-China has moved away from being the tail—meaning that it is fundamentally about global beta—to being far more resilient.

In 2023, the same sort of circumstance. The benchmark delivered approximately 10% U.S. dollar returns, so the MSCI Emerging Market benchmark. EM ex-China, however, was up 20% in U.S. dollar terms. And that was really not so far away from either the MSCI World or MSCI EAFE returns. So, this lower growth but greater resiliency has manifested itself in terms of actually good equity returns for the last few years in emerging markets ex-China. But China has really been a huge drag. Chinese equities are now down 50% in U.S. dollar terms over the last three years.

How to Remain Underweight in China

Dan Lefkovitz: China, as you said, is such a big part of the universe, and you have significant absolute exposure there, even if you’re underweight. Maybe you could talk about why you’re underweight and just how you approach a market that’s such a big percentage of the benchmark.

Leverenz: Well, I must first say that we have never been overweight China in the 27 years of this fund’s heritage. And the reason we’ve never been overweight in China really comes down to two things. The first is diversification. I don’t structurally want to have more than 20% of the fund’s capital in any particular country ever. And the second is ultimately about the fact that while China is inescapable, it’s a very large and dynamic economy even today, despite relatively tepid growth. It has historically been a very challenging place to invest from a bottom-up perspective. It’s a bit like Silicon Valley over the last five or 10 years. If you go back to Silicon Valley’s heritage in the 1960s, the 1970s, the 1980s, it was really in terms of venture capital funded by operators with relatively small pools of capital that were incredibly disciplined about the allocation of that capital in terms of new rounds and milestones.

What you had in the last 10 years, in the world where software was everything, the software eats the world environment, which was one of the reasons for U.S. exceptionalism in the last 10 years, discipline had completely failed certainly two or three years ago, and it was no longer run by operators, it was run by former Wall Street individuals who moved to Silicon Valley with a very different approach. You think about Tiger Global or SoftBank and these sorts of things. And I think the analog with China is actually quite interesting. China has been an incredibly dynamic growth environment for a long period of time. I can’t forget that when I lived in China or when I left China, it was roughly a $2 trillion GDP economy. This was in 2004. And today, it’s an $18 trillion economy. There was an enormous amount of growth and prosperity that happened in China. But like Silicon Valley, because China’s fundamental problem is it saves too much, there was an enormous amount of competition that was reckless and too much capital to fund a lot of misadventures. And so, the problem investing in China historically has been that even sensible companies with recently decent businesses have faced both reckless competition and also not particularly good capital allocation because the cost of capital is very, very low. I think that’s changed or is in the process of changing in a very visible fashion. And that’s one of the reasons that I think that China perhaps over the next few years could emerge as one of the best opportunities for investors around the world.

U.S.-China Tensions

Benz: Can you talk about how U.S.-China tensions have affected your thinking, if they have?

Leverenz: I am under no illusions that the global environment has become incredibly averse. I think investors, while they’re mindful of this, they don’t really think about this enough perhaps. We had a terrific period from the late 1980s, the early 1990s when two things were happening for almost 30 years. The first thing was after the demise of the Soviet Union, we had an enormous globalization of everything—capital flows, trade, ideas, human talent, and immigration. And at the same time, we also had structurally, since the Volcker administration at the Fed, an environment of ever-declining interest rates. Both of these were phenomenal for the world in terms of human prosperity. However, the distribution of those gains was the beginning of where we have a very unsettled world in terms of the rise of nationalism and increased division across most democracies and that sort of thing. The geopolitical environment has changed dramatically in the last 10 years. It has become a much more multipolar world where you have significant regional powers in Europe, the Middle East, Asia, and even Latin America, although it is a relatively benign security environment. I think we’re also, as the late Dr. Kissinger suggested, we’re in the foothills of a new Cold War. And so, I’m under no illusions that the relationship between Beijing and Washington will continue to remain tense structurally.

Finding Opportunity in China

Lefkovitz: From a bottom-up perspective, maybe we can talk about where you are finding opportunities in China. You seem to have quite a bit of consumer exposure there—Yum China, H World, which is a hotel chain, and some Tencent. Maybe you could talk about your seeming faith in the Chinese consumer.

Leverenz: China has been a really difficult place, obviously. As I suggested earlier, the entire CSI 300, a broader group of equities in China, are down 50% in U.S. dollar terms over the last three years. It has been a very painful slide, and it’s also been a very painful circumstance for fund performance, because the winning strategy over the last three years was rather simple, which is how underweight you were in China or having no capital in China. Today, we have 17% of the fund directly invested in China, really in three clusters. We have three companies that are very consumer-facing, as you suggested. So, there’s Yum China, H World, and also ZTO, the express company. And we have approximately 5% or 6% in three technology companies: Tencent, NetEase, and Pinduoduo. And then the balance of it is spread across China’s biotech sector.

All of these companies have been lost in translation in the sense that the concerns about China’s macroeconomic circumstance, and then also some of the geopolitical issues that we just referenced, have completely overwhelmed the reality of the underlying businesses. And that always, for investors, I think represents an opportunity when the focus is on nonidiosyncratic circumstances of businesses. And when I look across the balance, and they’re all quite different companies, I think as I suggested before, one of the really interesting opportunities in China has been a wholesale strategic reorientation across private-sector China. An acknowledgment across all the companies we own that China is going to be a slower growth environment over the next many years. And these companies have resolutely focused increasingly on the core, abandoning interesting ancillary opportunities to improve underlying margins and free cash flow with the purpose of, in most cases, using that enhanced free cash flow for distribution shareholders, and particularly share buybacks. I’ve been involved with China for over 30 years, and I have never seen the level of commitment in terms of very large buybacks that are going on at present.

And so, I think, investors often—this is not just China-specific, this is also emerging-markets specific—investors often misunderstand the opportunity in emerging-markets equities, thinking that if you identify the hot growth economy, you’re inevitably going to make a lot of money. As I said earlier, China’s economy over the last 20 years has come an enormous way. It was a hot growth economy. But over those 20 years, there have been almost no absolute U.S. dollar returns across the equity markets. If you look broadly across emerging-markets equities, some of the greatest returns have been relatively pedestrian, real economic growth economies like here in Mexico City. So, I think, eventually, since China has been almost abandoned by foreign investors over the last couple of years, investors will eventually come around to the fact that not only these companies are incredibly attractive in terms of valuations, but they’re also very promising at the idiosyncratic level of the competitiveness in their businesses, and they are distributing significant returns to shareholders. So, we’re nearly 1,000 basis points underweight in China, which over the last couple of years seemed like not being enough. But I do hold great promise in each of the companies we have in the portfolio in China.