Investors typically look to emerging markets for diversification from their U.S. holdings. But these days, holding the most popular emerging market investments amounts to doubling down on the artificial-intelligence themes driving U.S. markets.
The Magnificent Seven have nothing on emerging markets' semiconductor trio. Taiwan Semiconductor, Samsung Electronics, and SK Hynix account for 30% of the MSCI Emerging Markets index, which is up 22% this year -- double the gain of the S&P 500.
The broad emerging markets index is an even bigger bet on the wider tech scene, with information technology accounting for half the allocation. There's also country concentration: Some 70% of the index is invested in China, Korea, and Taiwan.
Investors looking for diversification in the event AI doesn't live up to its promises can find hedges within emerging markets, but they need to go beyond the index.
While Rory Green, head of China research at TS Lombard, sees emerging markets as well positioned for geopolitical and technology trends and likes their growth potential over the longer term, he warns that the backdrop for the rest of the year is trickier, given the run-up in South Korea's and Taiwan's stock markets and the strong growth coming out of the U.S.
South Korea is especially vulnerable, due to leveraged exchange-traded funds and a retail investor base that has been driving up to 60% of the market's moves -- an uncomfortably high level, says Charles De Boissezon, global head of equity strategy at Société Générale.
Another risk: Some Chinese chip makers are going public soon, with ChangXin Memory Technologie beginning to take orders for what is expected to be a $4 billion-plus offering on China's domestic Shanghai Stock Exchange. Their debuts could poke holes in the idea of a memory shortage, a theme that has driven South Korean stocks higher, Green says.
As fund managers trim some of their tech winners, many are taking a closer look at laggards. Young Jae Lee, an emerging markets fund manager at Pictet, sees the 30% of the index outside of Taiwan, South Korea, or China as more representative of the diversification opportunity that has drawn investors to emerging markets. Countries like Brazil, India, and even parts of Africa are home to growing working populations that drive increased income and consumption.
A burgeoning middle class buying cars, financial products, and other services is a good way to hedge against AI overconcentration, says Lee, who is also a co-manager on Pictet's recently launched Emerging Markets Rising Economies ETF.
Valuations in Brazil are sitting near historic trough levels even as its banks, telecoms, and other companies churn out stable earnings and high dividend yields, Young says. The country's fall presidential election looms, but Young sees a status quo situation if populist President Luiz Inácio Lula da Silva is re-elected.
In China, the domestic A-shares market and the CSI 300 index have outperformed the broader MSCI China index, which has fewer of the AI, industrial, and other companies getting the bulk of Beijing's support. Any pullback in the A-shares market is likely a buying opportunity, with Green expecting Beijing to come in and buy stocks if the market falls 10% or more.
But over the next couple months, he sees a better opportunity in the lagging MSCI China index, which is dominated by internet giants and consumer-oriented companies. Valuations on internet giants and some of the country's biggest consumer businesses are sitting near Covid-era lows. That is drawing the likes of Tom Harvey, senior equity specialist at Aberdeen Investments, who has taken some gains from AI-related stocks and put them in consumer companies -- including in China, where he thinks the worst is behind these companies.
Green also sees a possible catalyst ahead: Tencent Holdings is expected to launch an AI-embedded version of its ubiquitous WeChat app -- used by some one billion people -- possibly appealing to investors who had dismissed such companies as too slow on AI.
AI fatigue may make what was old hot again in emerging markets. If so, looking beyond the iShares MSCI Emerging Markets ETF exchange-traded fund or the Vanguard Emerging Markets Stock Index fund that track the broad index may be the way to go.
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