Emerging markets - don't panic

Alright, let’s try another tack – what about lack of a functioning democracy? Interesting, but didn’t you notice that, starting in April and running through to May, 815m eligible citizens voted in the world’s biggest fair election? This resulted in a transfer of power in India where the ruling and elitist Congress party was kicked out of office in favour of the comparatively upstart BJP party. And perhaps more significant – though less trumpeted – in October, for the first time in Indonesia’s history, political power changed hands from one elected president to another.

Okay, we know that the whole concept of ‘emerging markets’ is a bit contrived; an effort to lump under one heading many nations of different wealth, governance and resources. But, tell us, what is it that emerging markets – developing economies, call them what you will – have in common? It’s this: that shares in their listed companies are the first asset that cosseted investors in the developed world dump at the slightest sign of trouble. Thus, with emerging markets’ equities, there is one thing that can always be expected – volatility.

A bumpy ride

The year just about to finish did not disappoint. At the end of November the MSCI Emerging Markets index, which contains mostly state-controlled national champions, was 1.3 per cent down on the year and, in that period, fell 6.6 per cent on the month in January and 7.6 per cent in September. By contrast, the MSCI World index, which is dominated by global blue-chips such as Apple (Nasdaq:AAPL) and ExxonMobil (NYSE:XOM), was up 6.8 per cent on the year yet, more significant, only had to endure a 3.8 per cent loss in its worst month.

The longer term illustrates the greater volatility of emerging markets better still. In the five years to end November, MSCI Emerging Markets managed average month-on-month growth of just 0.2 per cent, yet produced this with volatility of 5.4 per cent. That means two-thirds of the time monthly changes were anything between a 5.6 per cent gain and a 5.2 per cent loss. Over the same period, MSCI World grew by 0.8 per cent a month and achieved that superior growth rate with less volatility – just 4.2 per cent.

This tells us that the turbulent ride that investors committed to emerging markets have to tolerate is really more to do with the tiny appetite that delicate investors have for risk and much less to do with the growth – or lack of it – that the underlying economies produce.

That said, it can’t help that a certain ennui has crept into the ‘emerging markets story’. It’s not exactly new and investors are no longer bowled over by the thought that a nation that has a stock market of sorts, a government claiming to be committed to liberalisation and a bit of a track record behind it can be a great home for their capital.

Despite that – or is it because? – investors’ attention is increasingly turning towards the so-called ‘frontier’ markets. These are the ones, such as Bulgaria, Tunisia and Vietnam, that have yet to progress to ‘emerging’ status. In the year to end November, the performance of MSCI’s Frontier Markets index topped both its Emerging Markets and World indices. Yet, consistent with the idea that assets in undeveloped markets are the ones that get dumped first, the Frontier index had a lousy October and November; so much so that a 25 per cent year-on-year gain in September was reduced to just 9.5 per cent by November’s close.

Still, there is no commanding reason to expect that investors’ perceptions will change in 2015. Emerging markets will continue to be the emotional asset of choice – buy it when you feel good; sell it when you are reaching for the antidepressants.

How the emerging markets are doing

Source: CIA World Fact Book; World Federation of Exchanges; national statistics

No end in sight

Even so, this instinctive response is at odds with both fact and likelihood – the fact that emerging markets have grown at least twice as fast as developed economies since the mid 1990s and the likelihood that they will maintain that trend through to 2020. According to data from the International Monetary Fund, emerging economies produced average annual growth of 5.2 per cent in 1996-2013. By contrast, advanced economies managed just 2 per cent. The IMF reckons the differential will continue, with average growth for emerging countries of 5 per cent for 2012-19 and 2.1 per cent for the advanced ones.

Granted, this is superior guesswork, the out-turn will be different and it may be tough to go along with the IMF’s notion that average growth in emerging markets will be faster in the four years 2016-19 than in the four years 2012-15 – 5.2 per cent versus 4.8 per cent. The hope is that, as this decade progresses, the developed world will recover from its post-credit crunch funk, pulling emerging markets with it. Maybe, yet the IMF’s assumptions seem to make light of the crushing burden that falls on China to power the world’s growth.

Look at it this way: just when investors had come to accept as commonplace that China’s economy would grow by 10 per cent a year, they had to grapple with the reality that – actually – 7 per cent or so would be the new norm. Yet even that pace is an enormous ask. To grow China’s $13.4 trillion economy even by 1 per cent is to increase output by the amount that New Zealand produces each year. To grow by 7.1 per cent, as the IMF forecasts for 2015, is to generate almost an extra $1 trillion – that’s the output of Australia or Saudi Arabia, the world’s largest oil producer.

Put simply, there is a limit to the number of new Australias that China can conjure up each year. After all, from where will the demand arise? The developed world won’t help much. If the US grows its economy by 2.4 per cent in 2015, as the IMF expects, that is an extra $420bn of spending, some of which will be satisfied by Chinese output. The EU will help even less. Its forecast 0.7 per cent rise in GDP will only generate an extra $100bn. Even combined, those two will hardly sustain the momentum in China’s export machine.

Therefore, more than ever, the emphasis will shift towards domestic demand and towards consumption rather than capital spending. True, there is a lot to go for. China is already the world’s second biggest consumer market with annual spending of approaching $4 trillion. The Chinese are the world’s largest consumers of Bordeaux wines; Apple has more stores in Shanghai than in San Francisco; Ferrari sells more cars in Chengdu, the capital of Sichuan province in south-west China, than it does in Milan and Turin combined. Behind these nuggets is the near certainty that, as China ages and becomes more affluent, its consumer markets will continue to grow rapidly. And as the country develops a welfare state, as it surely must, then that will only encourage people to save less and spend more.

Despite all this, the long-term trend in China’s growth rate will be down. It won’t be long before 7 per cent a year is too much to manage. When that becomes clear, investors shouldn’t view it as a crisis, though plenty will. It is simply the natural consequence of being big. Besides, it should still be many years – hopefully decades – before the country’s growth rate sinks to the sclerotic pace of the developed world. Throughout that period investors should have an exposure to what, by 2020, may be the world’s biggest economy and not – we stress – because of the size but because of that superior growth rate.

Of the major developing economies, China’s growth is likely to be rivalled only by India’s (see Table 2). And investor sentiment towards the world’s second most populous nation got a boost from spring’s election of Narendra Modi’s BJP party, with its business-friendly agenda and promise to create jobs.

India's challenge

Therein lies India’s greatest potential but also its toughest challenge. A demographic bulge means half of India’s 1.2bn population is under 26. That provides the manpower for growth. Other inputs are less certain. Can India’s underperforming educational system provide the skills needed for the 2020s – after all, technological advance means the world may not need another low-skilled labour pool like China’s in the 1990s? Can its government build the infrastructure that the country so clearly lacks or cut the red tape that entwines entrepreneurs?

Because it’s India, the best guess would be a qualified – a very qualified – ‘yes’. What does look certain, however, is that, if India can’t fill the growth gap, then the other two of the so-called ‘Bric’ nations – Russia and Brazil – certainly won’t. What can we say about Russia that hasn’t already been written recently? It is difficult to know whether Vladimir Putin’s increasingly autocratic approach to government is a cause or an effect of Russia’s weakness. What is clear, however, is that the contraction in Russia’s economy and the inflation that will accompany the fall in the rouble has the makings of a crisis. The hope is that needs must, so Mr Putin’s theoretical approval of a free-market economy will morph into practical market-friendly measures. Such a course would allow Russia’s entrepreneurs to restore some of the growth lost by falling energy prices. But that won’t happen overnight and, besides, somehow it seems too distant a prospect – Russia’s crony-capitalist élite have too much incentive to preserve the status quo.

It is too harsh to say that Brazil – the next biggest economy after Russia’s – increasingly looks like its dysfunctional neighbour, Argentina. Yet – much like Argentina – its governing classes rely on a system of political patronage that requires a bloated state, which inhibits growth.

Government spending sucks up 36 per cent of Brazil’s output, far too high a proportion for a developing nation. This reveals itself in various excesses. For example, the federal administration in the inland capital, Brasília, effectively lives in another country where incomes are 2.2 times the national average. Alternatively, Brazilians talk of the ‘Viagra effect’ on second marriages and pension costs. This is where the generous pension to a retired and aged public-sector employee is passed in full to his young second wife when the old man dies. As a result, the pension is paid for over half a century to cover a working life that lasted less than 30 years. Small wonder that ‘survivor benefits’, as they are known, cost Brazil about 3 per cent of its output compared with less than 1 per cent in the developed world.

In middle-income countries such as Brazil – or Russia and Argentina – the quality of governance matters much more than in poorer nations where simply the provision of basic services can spur growth. This may be why the IMF expects growth to remain much faster in emerging Asia than in Europe or Latin America (see Table 2). It’s largely a function of the base from which growth is coming. Asian success stories, such as Bangladesh, Sri Lanka and Vietnam, are still much poorer than their Latin American counterparts or their European ones, including Bulgaria, Serbia and Hungary.

All this points to the direction that investing in emerging markets should take. Be fussy. Distinguish between those markets that are quite likely to emerge and those that get the ‘emerging’ moniker simply because ‘perennially disappointing’ does not go down too well with the marketing people. This is another way of saying, favour Asia at the expense of the rest; though Africa may come in at the margins. It also means – as ever – take the long view. Buy and hold and – even if the markets themselves can’t manage it – stay calm.

Projections for growth in real GDP (%)

Source: IMF World Economic Outlook