Emerging markets in the era of friend-shoring

Key takeaways

• Multipolar, ‘geo-economic fragmentation’ is re-configuring the world’s supply chains, creating opportunities and challenges at national and corporate levels
• Covid and the Ukraine war have shifted the priorities from cost efficiencies to securing supply resilience
• Many emerging markets are ‘non-aligned’ and may continue to trade pragmatically with all geopolitical blocs
• We see five emerging economies as potential winners: India, Indonesia, Vietnam, Mexico, and Poland. Only India offers an investment case as a standalone equity allocation in our clients’ portfolios.

A major economic and political shift to a multipolar world is underway. The International Monetary Fund (IMF) describes the process of reinforcing manufacturing and trade links by diversifying regional or local supply and production as ‘geo-economic fragmentation.’ That trend will create corporate and national winners and losers, while likely reducing efficiencies and perhaps adding to inflationary pressures globally.

Strategic competition between the US and China, followed by the Covid pandemic and disruptions linked to Russia’s invasion of Ukraine, have all pushed governments and firms to reinforce their supply chains. Five years ago, the US and China began imposing tit-for-tat customs duties, adding friction to global trade. The number of corporations interested in moving production closer to their home market has jumped eight-fold since 2017, according to an IMF report last week (see chart).

In response, a new vocabulary to describe the process of reinforcing supply chains has emerged. ‘Re-shoring’ is defined as re-locating production to a firm’s home market, ‘near-shoring’ is to bring facilities closer. Historically, re- or near-shoring was motivated by cost. A decade ago for example, textile producers left China as wages rose in favour of lower-cost countries such as Vietnam. In contrast, friend-shoring aims to concentrate production in allied countries to ensure reliable supply between allied economies of different income levels. While higher trade barriers between competing blocs and redundant capacity building would be negative for the global economy, businesses have demonstrated the ability to diversify resources, labour, and capital across markets while re-routing trade around restrictions.

From cost to resilience

US/China tensions, then Covid and the Ukraine war created new geopolitical catalysts in addition to cost. Industries have to address the resilience of their supply chains in an era when energy and medical supplies have become strategically important.

The US has long considered semiconductors essential to its economy. Legislation in 2022 was designed to reduce dependence on foreign-built computer chips and dissuade investment in Chinese technology. This year the Inflation Reduction Act encouraged businesses to build in America. The country has had limited success in persuading others to join its restrictions. In February, the Netherlands imposed restrictions, and then in late March Japan agreed to tighten export controls of 23 types of computer chip materials, effective from July. The EU is more focussed on diversifying its supply chains, rather than cutting off Chinese production, and views US industrial subsidies as a threat.

Read also: China’s Great Reopening

Non-aligned and opportunistic

Many nations remain ‘non-aligned’ to avoid a binary choice between China and the US. This division is clearest in discussions around the war in Ukraine. The US, EU and its allies are committed to supporting Ukraine, and make up a group of 52 nations, according to research by the Economist Intelligence Unit. Only 12 countries, including Belarus, Myanmar, Serbia and Syria, back Russia. Nevertheless another 127 nations, from India to Brazil and South Africa, remain neutral. They take a practical and opportunistic trade approach, the report says.

As many economic development successes have been achieved through export-driven models, such as the ‘Asian tigers’, or strong foreign direct investment in the case of a country like Poland, a worsening global trade and investment governance raises questions over the long-term prospects for less mature emerging markets. The IMF shows that under most geopolitical scenarios, emerging and developing markets would be worse off if they are forced to choose between aligning with one bloc over another. The IMF also suggests that non-alignment may leave emerging markets relatively unscathed by fragmentation by taking market share while keeping access to many foreign markets, capital and resources. The risk for non-aligned nations is that the US and China try to incentivise economies into their “friend-shoring” networks.

Nevertheless, geo-economic fragmentation should also, over time, shorten supply chains as well as let manufacturers respond more quickly to changing consumer demand. The result may be more regional as corporations create hubs to supply their production and distribution networks. While that may create self-sufficient collaboration within the blocs, it will do nothing for competition, leaving similar products more expensive when compared between regions. More of North America’s manufacturing may, for example, move to Mexico, which has cheaper production costs than the US or Canada, but remains more expensive than many others. As BlackRock CEO Larry Fink pointed out in March 2022, production inefficiencies are inherently inflationary.

Emerging winners

If global supply chains and investments do fragment, emerging markets will fall into three broad groups. The first includes highly industrialised economies such as South Korea which are important to global technology supply chains. A second group of natural resource exporters, including Saudi Arabia, may try to remain non-aligned and focus on long-term development and maintaining stable prices. The third group will include countries which are already gravitating toward a specific bloc but looking for stronger inducements, such as India and ASEAN countries.