A map being redrawn

The last five years have delivered a hat trick of major shocks that motivated governments and businesses to swiftly move away from a “just in time” mentality focused on price and efficiency to a “just in case” mindset prioritizing reliability and resilience. We are, of course, referring to the US-China trade tensions that broke out in 2018, the COVID-19 pandemic, and Russia’s invasion of Ukraine.

Terms such as “nearshoring,” “friendshoring,” and “allyshoring” have become commonplace in financial media, and companies have increasingly announced or discussed a reshuffling of global supply chains. Yet, there is reason to believe this trend is only in its infancy. The UBS Evidence Lab C-Suite business survey of 2023, for example, found that 70% of executives in the US, 78% in Europe, and 54% in China are planning to move parts of their supply chain closer to home.

At the same time, investors should avoid adopting extreme characterizations. As Raytheon Technologies CEO Gregory Hayes said in an interview with the Financial Times this week: “We can derisk but not decouple,” adding his company has “several thousand suppliers in China” and that he believes this is the case “for everybody.” Hayes adds: “Think about the USD 500bn of trade that goes from China to the US every year. More than 95% of rare earth materials or metals come from, or are processed in, China. There is no alternative.” If this is true of Raytheon, one of the largest US aerospace and defense manufacturers, a similar conclusion likely applies to most companies in less geopolitically sensitive industries.

Earlier this year, when many observers were loud with prognostication on the demise of the US dollar as the global reserve and trading currency, we argued that we are gradually moving toward a more diversified, yet still dollar-centric, global currency order. In a similar vein, we would assert that we are moving toward a more diversified, global supply chain order—yet one in which China maintains a critical role.

Recent developments support this conclusion: US imports from China, for example, are still growing in US dollar terms, yet their share has contracted from a peak of 22% of total US imports in 2017 to 17% last year. The early winners from these rearrangements were Asian markets such as Vietnam, South Korea, Taiwan, and Thailand. More recently, Mexico and India have attracted a burst of investment commitments by foreign companies, gaining significant media attention.

Manufacturing investment in the US may also be entering a renaissance, fueled by recent legislation such as the Inflation Reduction Act and the CHIPS Act, combined with restrictive controls on exports of cutting-edge semiconductors to China and an expected executive order limiting US companies’ outbound investment in select circumstances. And while efforts are being made to mend US-China tensions—notably with this week’s visit of State Secretary Anthony Blinken to Beijing—current expectations are for relations to stabilize at best. An improvement is a more complex undertaking.

In a world in which supply chains and foreign investment routes are rapidly being redrawn, we continue to underscore the importance of geographic diversification in investment portfolios. In this context, we are seeing a great opportunity cost from the fact that global investors do not own enough emerging market assets relative to historical averages, as some of these markets stand to benefit the most the abovementioned trends.

In our view, both emerging market equities and bonds merit a most preferred stance in portfolios on the back of attractive valuations and stable-to-improving fundamentals. On some of the nearshoring standouts, we have upgraded our outlook for Indian stocks thanks to the country’s better-than-expected growth in the first quarter; softening inflation leading up to a potential policy rate cut in late 2023; narrowing external deficit; and less demanding equity valuations than a few months ago.

Mexico’s economy, in turn, remains in good health, with no major fiscal or external sector imbalances. We expect the Mexican peso to remain well behaved; hold a positive view on local-currency fixed income; and find attractive opportunities in USD-denominated corporate bonds. Finally, frontier market equities, of which Vietnamese stocks make up almost one-third of the universe, remain one of our preferred long-term investment themes.

As these trends continue, we hope that emerging market assets find their rightful place in your asset allocation.

Co-authored with Alejo Czerwonko, CIO Emerging Markets Americas

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