TSM - EEM: We Consider China Uninvestable

2023-08-30 11:26:13 ET

Summary

• iShares MSCI Emerging Markets ETF is heavily exposed to China, Korea, and Taiwan, all of which face major geopolitical risks.
• The risks associated with these assets, including potential permanent impairment and demographic challenges, make the EEM ETF unappealing at its current valuation.
• You can buy solid businesses for the same multiple as EEM with almost none of the existential risks. It is not an ETF we would consider.

The iShares MSCI Emerging Markets ETF ( EEM ) is quite exposed to China. Otherwise, it is exposed to South Korea and Taiwan. Why South Korea is considered an emerging market is unclear, but ultimately all these markets have major issues. Korea less so, but even they have a sword of Damocles hovering above them in terms of geopolitical risks. That's what it comes down to - the geopolitical risks are severe, and in an age of economic nationalism these markets are being driven by stocks which have a lot of downside as deglobalization becomes the new regime. The EEM 11.6x P/E is really not enough to compensate for the risks.

EEM Breakdown

Let's start with some of the top holdings and the geographical exposures to get a mapping of the ETF.

The ETF is actually very diversified. There are more than 1,000 holdings. However, there is skew towards a couple of the mega-cap companies that trade in these 'emerging' markets.

Among them is Taiwan Semiconductor Manufacturing Company Limited ( TSM ) aka TSMC, Samsung ( SSNLF ) and then several Chinese stocks trading as ADRs in the U.S. or on the HKSE. Let's jump right to the Chinese holdings. While the delisting issue is in the past , many companies now have alternative HKSE listings in order to assure some continuity of ownership and an alternative for ownership for foreign investors. However, the core issues remain around the investability of China .

The first matter is the sanctity of these markets and the respect for foreign capital in these businesses. While there has been a lot of praise for China's state capitalism over the years, the Ukraine war and the consequent economic nationalism has highlighted the risks in Chinese businesses that the rights of shareholders could be arbitrarily superseded by the government, or at the least capital controls such as those in Russia could be instituted in China as well if tensions were to rise between the East and the West even further. Triggers of more tensions could be an invasion of Taiwan, which remains part of the 'internal' policies of China, and could trigger major international backlash, although it is unclear if Europe will have to appear to care about such an invasion, especially with the costs that will come from further economic alienation of a major manufacturing hub. The U.S. would likely have to sanction China in some way, but who knows as they may do nothing in order to maintain economic order.

While geopolitical factors and relative geopolitical power matter for how the tensions between China and the U.S. will develop, there is a non-negligible risk that foreign capital in China could become impossible to retrieve. Even without capital controls, the slew of crackdowns on videogaming and on popular CEOs exemplifies the general issue of shareholder unfriendliness in Chinese markets and the elevated risk of taxation and regulation around businesses that may be performing abnormally well.

TSMC and Samsung are also exposed to further tension with China. Samsung is struggling with the fact that Chinese markets are becoming more hostile as a trading partner to Korea, due to its affiliations with Western and capitalistic powers. There is a decline in demand for Korean-sourced products already in China that is impacting sales. Furthermore, Samsung in particular has to navigate the chip ban, and as a major beneficiary of American technology its ability to leverage the proximal Chinese market is highly limited, and Samsung alone has been dragging on Korean indices due to these concerns. Furthermore, there is a heightening risk of a broader chip glut around economic concerns both in China but also globally around the inflation fight.

TSMC is exposed in that its assets are in Taiwan and could become impaired in the case of an invasion. They are trying to diversify their assets into the U.S., but the success and timelines for this venture do not assure downside protection in TSMC.

Bottom Line

China is 30% of EEM. Taiwan and Korea are another 27%. All of these are exposed to rising geopolitical tensions and the uncertainty around state capitalism's respect for shareholder rights and commerce-led markets. The expense ratio is also high on the ETF at around 0.69%. With the risks associated to these assets being permanent impairment, one must think twice.

Also, the demographic situation in both Korea but especially China is appalling. China is the fastest-declining population in the world, worse than even Japan. On top of a faltering real estate market, which is moving into a long deleveraging after a speculative bubble in the making for more than a decade, and an economy that is in its plurality exposed to the construction industry, both organic and endogenous factors, but also exogenous factors all play against this ETF in a secular horizon. Especially at an 11x P/E, which is the multiple you can buy pretty resilient, inflation-hedged U.S. or Japanese businesses for, there is not a compelling case for iShares MSCI Emerging Markets ETF.

For further details see: