The world's best growth markets

Emerging markets. For so long associated with the promise of massive returns, now instead two words sure to bring a shiver down many an investor’s spine. It’s not hard to see why. Political uncertainty, social unrest and corruption aren’t exactly high on many investors’ shopping lists. And what if the US Federal Reserve prompts another taper tantrum? Emerging markets, still beholden to the big beasts of US monetary policy and Chinese commodity demand, could find themselves in the line of fire again – especially as their lack of development means they are less able to withstand such financial shocks.

Bric and emerging markets indices have certainly suffered heavy losses in the past few months on the sum of these many fears – erasing some of the gains made since the last round of speculation over the implications of any withdrawal of stimulus by the Federal Reserve. The benchmark MSCI Bric index is down nearly 7 per cent over the past three months. Over five years its annualised return is a negative 1.7 per cent.

That’s far short of the returns from the relative safety of developed markets. In fact, it is the US that has been the best performer of any major market or group of markets over the period, returning an annualised 14 per cent. Even ‘sclerotic’ Europe has beaten the Brics (Brazil, Russia, India and China), with the benchmark eurozone MSCI index returning an annualised 0.75 per cent a year. You’d be forgiven for thinking emerging markets investing is more risk than reward.

Time for a rethink

But steering clear of emerging markets altogether brings its own set of risks. Whatever the recent underperformance, Bric economies have been solid performers over a longer time frame. Over 10 years – and despite a dismal half decade – the MSCI Bric Index has still returned 8.6 per cent a year, a full 3 percentage points more annually than its US counterpart and quadruple the annualised return from the UK. Indeed, until five years ago emerging markets had proved a saviour, rescuing many investors from a lost decade of uninspiring returns in developed markets. In the past, higher risks have indeed been rewarded with higher returns.

As we discuss in this week’s big theme on pages 46-47, investors of a long-term mindset should still pay attention to the role emerging markets can play in their portfolios. The simple concept of mean reversion suggests that such stark developing world outperformance will not continue indefinitely – and correlations between developed and developing world equities are weak, so when one is weak the other tends to be strong.

That’s a useful characteristic that makes them a very useful way to introduce diversification into your portfolio – asset allocation models suggest that a balanced investor should hold around 5 per cent of their portfolio in equities; a more risk tolerant investor may stretch this to 10 per cent. And in fact portfolio theory suggests that gaining exposure to emerging markets could reduce the risk in your portfolio – because over the long term the higher volatility should be compensated for by higher returns.

One reason why retail investors have perhaps been less keen to embrace emerging markets investing is simply that it has been too expensive – fees on the actively managed products that have dominated the retail landscape tended to be higher than developed market equivalents, due to the greater costs of accessing those markets. Other emerging market asset classes such as sovereign and corporate debt, which could add an even greater diversification benefit, have proved more difficult to access still.

But many products are now emerging that would allow you to add similar diversification benefit to your portfolio, beyond the crop of Bric-focused products that sprang up a decade ago. Exchange traded fund (ETF) providers, in particular, are expanding their offerings across smaller emerging markets. As the table on page 28 shows, some of these have recently delivered returns far in excess of those more commonly associated with Brics of late. That’s worth taking notice of, because just as momentum strategies work at an equity level, so they work at a market level.

The best growth markets

What do South Sudan, Sierra Leone and Turkmenistan have in common? The answer: they were, respectively, the three fastest-growing economies on a real GDP basis in the world last year, according to the CIA World Factbook.

While it is the Bric economies that, by virtue of their sheer size, attract the most attention – and money – when it comes to emerging markets investment from developed economies, they are by no means the fastest-growing economies in the world. South Sudan grew 24.7 per cent in 2013, more than three times the rate of China and 20 times that of Russia.

South Sudan, Sierra Leone and Turkmenistan are all still, despite their rapid recent growth, tiny economies – and all are impossible for investors to access outside of pooled frontier funds. But there are plenty of countries around the world with the potential to become economic superpowers in a matter of years.

So, just as Goldman Sachs economist Jim O’Neill coined the term Bric in 2001, so economic crystal ball gazers have been busily trying to repeat the trick of spotting the next big things among the world’s myriad developing economies – so far they’ve come up with Civets, the Next Eleven and Mint (see list, page 26)

Such acronyms have been dismissed by some as marketing gimmicks – Barclays’ analysts recently described the groupings as “a vast oversimplification”. Certainly there is much hidden economic complexity lurking in emerging markets investing – the different characteristics of emerging markets makes them more or less capable of dealing with situations such as commodity price deflation or rising US interest rates. And there are notable omissions from the lists, too – take Thailand and Malaysia, for example, which along with a host of eastern European states have moved well up the development curve but still offer significant growth potential.

Their authors would claim, however, that the point of these exercises in futurology, and simplification, is to cut through the sea of economic data to help steer investors towards those most countries offering the promising returns. And in some cases they appear to have spectacular track records – Brics returned around 500 per cent in the five years after Jim O’Neill coined the term – although on other scores they have proved woefully wide of the mark.

Market picking

So what, putting the IC’s stockpicking hat on, if we could identify the next set of economic superpowers before they made it to the big time? There’s certainly plenty of economic data to go on from organisations such as the World Bank, International Monetary Fund, and OECD – even if delving through it can seem somewhat overwhelming.

However, there is a school of thought that for investors such effort would simply be a waste of time, and that a country’s rate of economic growth doesn’t matter very much at all. That’s because, while intuitively it isn’t easy to separate the idea that a nation can be successful and its markets not, and vice versa, the reality is that rapid economic growth does not always translate into strong investment returns.

China’s last five years are a case in point: GDP has continued to rise at a rapid rate in excess of 7 per cent a year, but – depending on what index you choose to look at – returns have either fallen or, at best, risen in low single digits. That and the underperformance of markets in other fast-growing Bric economies could be because higher rates of growth were expected and already factored into valuations. And there’s plenty of statistical evidence that shows a low correlation between GDP growth and stock market growth over the long run. In 2011 our economist Chris Dillow analysed 44 developed and developing economies and found in fact that the relationship between GDP and market returns was negatively correlated.

However, Chris’s analysis does suggest GDP growth may matter more to investment returns over the shorter term – although that would require being better able to forecast GDP growth than others, a near impossibility in an information efficient market. No matter, though, because as India’s recent market strength shows, even just the prospect of economic reform can be an equally powerful influence upon markets – investor wariness of emerging markets often stems from deep-rooted structural issues that the right leadership can potentially overturn. Recession-struck Brazil will be the next market to test this theory – its main index, the Bovespa, has had a dismal run in the build up to its presidential elections, but jumped 9 per cent in three days after pro-business opposition candidate Aecio Neves did far better than expected in the first round of voting. China has enjoyed a decent year, too, as its president Xi Jinping, selected last year, has sought to rebalance and reform its once state-dominated economy.

As the laggard in the pack it’s a lesson, perhaps, that Russia’s politicians need to learn, too – and one private investors looking to add emerging markets’ exposure to their portfolios should be mindful of: where reform treads returns follow.

Red alert

China’s reforms make it attractive to investors – Russia should take note, says John Hughman.

China is on the cusp of taking over the mantle of the world’s largest economy from the US this year. Yet to most of us on the outside it remains, as Churchill once said of Russia, a riddle wrapped in a mystery inside an enigma.

Churchill believed that there was a key to understanding the intentions of Russia: national self-interest. Perhaps such a key explains the actions of China, too, a nation following a similar path from totalitarian communism to democracy (albeit democracy of a somewhat authoritarian nature; witness the demonstrations in Hong Kong this week).

China has, ostensibly, been far more successful in this transition than Russia appears to have been – the former has eased into its role as global superpower over many years since adopting a market system in 1978; Russia collapsed into chaos after the collapse of the Soviet Union prompted its transition in 1991 and has faced an uphill struggle to regain its economic poise ever since, despite a 10-year commodity boom.

Economists have argued at length over the reasons for such relative success, with an often cited culprit the relative speed at which the respective countries sought to rebuild their economic models. In short, some say, Russia tried to – or had to – change too much too quickly, including its entire political system. In China existing bureaucracy was left largely unchanged – the Communist party remained very much in control, even if its politburo took a much more laissez-faire attitude towards its relationship with a capitalist system. Others put politics entirely to one side and suggest that China’s relative success was simply that, coming from a much lower starting point – lower GDP per capita, smaller urban population – it had much further to grow. In fact, Ray Dalio, founder of US investment company Bridgewater Associates, believes low per-capita incomes are the most important indicator of future growth. On that basis, India clearly has most potential (see table right).

Such enormously simplified musings are somewhat moot, however, in the context of the countries today – and what their respective situations mean for investors. What both countries do in the years ahead will exert a massive influence on the wider investing world – as market wobbles in the wake of slowing Chinese growth or Russian military interventions amply demonstrate.

But is there a case for investing in their own markets? Certainly in valuation terms alone both China and Russia look cheap – the latter especially so on a forward PE ratio of less than four, lower, in fact, than the market average dividend yield.

Russian bear market

That is, perhaps, a reflection more of the country’s rather stunted political development than its economic prowess or potential, culminating in the recent imposition of economic sanctions by the west. That action is pushing up inflation in the country, and the resulting weaker rouble – at record lows against the dollar – is exacerbating an already weak economy which is expected to grow just half a per cent this year.

Sanctions aside, Russia’s oil and gas dominated market is suffering as a result of weakening energy prices. And capital flight means companies, already lacking investment, are also unable to refinance dollar denominated debt as a result of sanctions – Rosneft, for one, has loans of $26bn (£16bn) due by the end of next year, while the total owed by Russian companies to foreign lenders is believed to stand at around $700bn.

Meanwhile, age-old structural problems remain prominent. Confidence in corporate governance is low, not helped by frequently fractious relationships at western ventures into the country – witness BP’s spat with joint-venture partner TNK. And corruption remains a problem across the country, as the circumstances surrounding the recent arrest of oligarch Vladimir Yevtushenkov – whose business Sistema has listed GDRs on the London Stock Exchange – suggest.

Yet there remains no sign of reform on the cards – economic or democratic – so to cut a long story short it’s a bear market we’d still avoid no matter how cheap it looks on paper.

China: chipped but not broken

China appears, at first glance, more stable – even in the face of the pro-democracy movement gaining momentum in Hong Kong. But the country is not without its problems, too – ones that even the strong arm of president Xi Jinping may struggle to resolve.

He also has graft on a massive scale to deal with, although appears to have the will to do so after a number of high-profile prosecutions. More pressing still is the task of weaning its economy off of infrastructure investment and the mountain of debt the country continues to build up as a result. Despite its huge size, public debt is now at least 200 per cent of GDP, although some estimate the actual figure to be closer to 250 per cent when other forms of borrowing such as shadow banking are taken into account – more troubling has been the pace of increase, a hundred basis points in the last five years.

Partly responsible for that are so-called local government financing vehicles, which have been used by cash-strapped regional governments to circumvent restrictions on borrowing. These are proving a particular source of worry, to the extent that the government has now imposed strict criteria on LGFV borrowing and said that it will not bail out any local authorities that are at risk of default. Earlier this year, a senior Chinese auditor expressed concern that such borrowing “could spark a bigger financial crisis than the US housing market crash”. Others are less concerned, pointing to the fact that because much of China’s borrowing binge has been funded domestically and because its banks are state-owned, risks of widespread default are low.

Nevertheless, the World Bank has pointed to a “disorderly deleveraging” of local government as the main threat to Chinese growth, and believes “intensified policy efforts” to address such financial vulnerabilities and structural constraints mean GDP growth over the coming years will be lower than previously expected, dropping to 7.4 per cent this year, 7.2 per cent in 2015 and 7.1 per cent in 2016.

A cooling housing market is also contributing to that slowdown – prices have been falling steadily in regional cities as a result of excess stock, slipping a percentage point in August, the fourth straight month of decline. However, most suggest there will be a period of adjustment rather than a crash, while more general fears of a hard landing now look wide of the mark, given the inherent strength underlying its economy. In fact, China’s slowing growth appears to be a path it has chosen rather than one forced upon it and, more importantly, economic reform is gathering pace. “China is in the midst of an economic transition that is now entering its most defining stage,” said analysts at Barclays. “The slowdown in China is not indicative of a deteriorating economy, but a by-product of a much needed transition from an investment-led commodity intensive growth model to one that is more consumption oriented.”

It believes successful reform will be a potent long-term driver for equity performance – in particular, it argues that the reform of state-owned enterprises has so far been overlooked by the market but could reap huge rewards for investors as governance and profitability improve and the playing field for private enterprise is levelled. The ongoing liberalisation of foreign ownership of Chinese shares could also attract more capital to Shanghai’s stock market – all the more attractive at its current lowly rating, with equities trading at a 32 per cent discount to their 10-year historic average and, according to Barclays, looking extremely oversold. Now could be the time to chase the dragon.

Indian summer

A revitalised India looks like a good bet, says Graeme Davies.

India’s star is in the ascendant once more. After a period during which its previous stellar growth appeared to be stagnating, held back by crippling inflation, a run on the rupee and weakness in the face of net outflows from its economy as the emerging markets suffered from ‘taper tantrum’ last year, India has bounced back. And although such events are merely symbolic, the recent celebrations at India becoming only the fourth nation to pitch a satellite into orbit around Mars coupled with prime minister Nahendra Modi’s triumphant tour to the US, which featured a rock star-like appearance at Madison Square Gardens in New York, suggest a new found confidence in the subcontinent.

While its fellow nations in the Bric group of most ‘developed’ emerging markets have run into varying degrees of trouble, India’s fortunes have taken a noticeable turn for the better. Many point to the May election of BJP party leader Narendra Modi as prime minister with a rare working majority as the catalyst for the upturn in fortunes, but in truth India has been showing signs of emerging from a tough period since the turn of the year.

Indian stock markets began to pick up before Mr Modi was elected and have continued to surge to new highs in the months since he assumed power, driven by improving economic growth, a sign that inflation may finally be abating and the strengthening of the rupee against the dollar, which has led to a shrinking fiscal deficit and growing foreign investment.

Deepak Lalwani, director India at Lalcap in London, explains the recent stock market surge: “It’s the first time in 25 years there has been an outright majority. In the past coalitions held back progress but political uncertainties have been cleared and this is why the market has raced ahead, but it is not roaring ahead. At the moment it is hope – of transforming the economy at a national level as he [Modi] did at state level. He has started to deliver on the low hanging fruit. The best analogy is Great Britain in the 1980s. There has been no big bang reform but he has started with the bureaucrats, such as dismantling the planning commission, which is helping sentiment.”

Modi magic

Mr Modi was elected on an unashamedly pro-business ticket with the pledge that he would replicate the success he has enjoyed as leader of Gujarat state on a national scale. The challenges are multiplied hugely when one considers India is a combination of 29 states and home to more than 1.1bn people and many of its institutions remained mired in the socialist mindset which dominated its post-independence years.

But he has inherited an economy that appears to be entering an upswing under the steady guidance of Reserve Bank of India (RBI) governor Raghuram Rajan, a former International Monetary Fund economist. During 2012 and 2013 the Indian economy showed signs of stalling as the authorities were forced to hike interest rates to combat rising food inflation, the bugbear of India’s millions of poor. This dampened domestic consumption, and with it GDP growth – India has long been as much a domestic consumption story as an export one, with up to 60 per cent of demand in its economy coming from domestic sources.

But the RBI’s discipline may finally be paying off as inflation is showing signs of abating, boosted by a good monsoon harvest season and there is hope that the end of this year or early next year at the latest will see the first interest rate cuts. The latest RBI meeting at the end of September saw interest rates retained at 8 per cent and governor Rajan says the consumer price inflation outlook is balanced “with a slant to the downside” with risks to the January 2016 target of 6 per cent “still to the upside though somewhat lower than in the last policy statement”.

This long-term discipline from the RBI is welcome and should, not withstanding external factors, see inflation, which was 7.8 per cent at the end of August, trend down gradually over 2015. As Bhanu Baweja of UBS told Bloomberg: “The big positive lies in the correct diagnosis of the economic situation, which I think the previous government was completely ignoring. The big positive also lies in the way monetary policy is being conducted with a long-term view.”

Part of governor Rajan’s plan has also been to bolster the country’s foreign-exchange reserves while the rupee has been relatively strong to help build a buffer should the situation reverse, something that has helped insulate India somewhat compared with other emerging markets during the recent dollar surge.

And the Indian economy is showing signs of picking up pace once more, with the latest quarterly GDP growth figure of 5.7 per cent the first time growth has come in ahead of the 5 per cent mark for two years. This has lent credence to RBI forecasts that GDP growth could reach 5.6 per cent for the year to March 2015 and push on towards 7 per cent and beyond within two years. The key to this will be continuing reform, lower interest rates and inflation and a continuation of the recent trend of increased foreign investment. As Mr Lalwani puts it: “India badly needs foreign capital for investment in infrastructure. The country needs strong and stable capital inflows.” One major recent development which will help to bolster the confidence of those investing in India was the upgrading of its credit rating by Standard & Poor’s from negative to stable, bringing it into line with other major credit rating agencies and returning Indian debt to investment status.

One major risk to this is a repeat of the ‘taper tantrum’ that blighted the economies of the emerging world last year when the first hints of quantitative easing tapering from the US resulted in a slide in emerging economy currencies and significant capital flight. But this situation was largely reversed in the opening eight months of the year despite the reality of US tapering, although recent dollar strength has begun to eat into the rupee’s recovery a little. Still, as many analysts have argued, India is better-placed to withstand such pressures now than it was even as recently as a year ago. The stronger rupee, improving economy and a canny curb on gold imports have reduced its current account deficit and foreign inflows have been strong. This, coupled with its improving economic performance and the expectation of further significant economic and labour market reforms, have further bolstered confidence.

The demographic dividend

Within the country itself, lifting the country’s hundreds of millions of poor out of poverty remains a major headache, especially considering the huge population boom which is likely to see 200m people enter the working population over the coming 20 years.

This so called ‘demographic dividend’ has been cited by many as a reason why India’s growth could outstrip that of China in the coming years. Where India’s youthful population is likely to catapult it into the role of the biggest nation on earth by the late 2020s, China’s one-child policy means its population is growing increasingly old. But as Mr Lalwani says: “The demographic dividend could become a demographic timebomb if India’s economy cannot create enough jobs.” For this to happen the government has to concentrate on education and skilling for the masses and reform of the labour market. Combined, these could potentially help lift India’s manufacturing sector from its current state where it represents around 15 per cent of the economy to levels required to support a booming working population. But this requires annual GDP growth in the region of 8 per cent each year over a prolonged period, a level it surpassed comfortably for a number of years before the financial crisis.

But the scale of the challenge in lifting India’s living standards should not be underestimated. At present, as much as three-quarters of the population live at subsistence levels or in abject poverty and the states that are growing the fastest are those that are the poorest. The country’s infrastructure is already groaning under the strain of supporting its population, and if its people number 1.7bn by 2050, as some estimates suggest, immense levels of investment are going to be required.

Make sense of Sensex

What does this mean for Indian equities, though? At the moment even the hope of significant growth has powered Indian markets, making them among the best performing of all global indices in the past year. The Sensex has risen by 33 per cent to 26,600 in the year to date and Citigroup recently forecast a further 18 per cent rise next year to hit 31,000 by the end of 2015. That’s because valuations have not run away with themselves yet and the market is only valued in line with its five-year average right now. And this is without growth reaching anything like the potential velocity it could hit in years to come. Of course, equity bull markets do not always follow the wider economic growth pattern and plenty of boom periods have not been matched by share price booms. But some commentators have begun to get pretty excited by the prospects for Indian equities in recent months, with the most optimistic hinting at a multi-year bull run to come.

The subcontinent has many factors stacked up in its favour which, if harnessed properly, could provide the next great growth story of the 21st century, and something investors would do well to take heed of. And now, under the leadership of Mr Modi, the chances of realising even some of its great potential are better than they have been for some years. Its growing population, entrepreneurial spirit, natural resources and wealthy and widespread diaspora offer hope as does the current sense of stability and coherence emanating from the RBI. Of course, huge challenges remain in building the infrastructure to support a 21st century economy, lifting its millions of poor out of poverty, stripping away bureaucracy and regulation to allow businesses to flourish, educating and skilling up a burgeoning workforce and creating a big enough consumer class to support the growth levels required for the country to meet its potential. But if Mr Modi even goes some way to achieving these aims during the coming decade, then India could be a worthwhile place to invest a sensible proportion of a diversified portfolio.