The rise of the emerging world, and especially China, has transformed the global economy over the past generation, while the past decade has transformed investors’ attitudes to its markets. Daniel Ben-Ami assesses where we are in an ongoing transition
The chart that probably best illustrates the spectacular rise of the emerging world in recent decades is the one that shows its surging share of global output (figure 1). Back in 1980 what the IMF classifies as emerging market and developing economies accounted for less than a third of the total, on a purchasing power parity basis. By 2013, they accounted for over half, taking a substantially larger share of a global economy that itself had grown substantially. Even based on market prices, the share has risen from 24.5% to 38.7%.
The rise of China accounts for the bulk of this shift. It rose from about 2% of global output in 1980, shortly after the market reform process had started, to about 15% in 2013 (measured at PPP). Three decades of rapid growth transformed it from a dirt-poor backwater to its current position as the world’s second largest economy. But even leaving China aside, the developing Asian region grew spectacularly. In contrast, Latin America’s share of global output fell substantially over the same period.
Of course there is no straightforward relationship between economic growth and investment returns. If there were, investors in Chinese equities would have enjoyed a bonanza – rather than the rollercoaster ride that they have, in fact, endured. However, the rapid economic growth of emerging markets for many years did provide the basis for the orthodox case for investing in emerging markets. Essentially, the mainstream view was that emerging market investors enjoyed the potential for greater growth but at the price of higher risk. Bouts of volatility such as the 1994 ‘tequila’ crisis in Mexico and the 1997-98 Asian financial crisis were a reminder of the dangers involved.
In recent years, the main financial and economic premises behind this orthodoxy have started to break down. On the financial side, the assumption that investing in emerging markets is inherently more risky than in the developed world has been called into question. The global crisis of 2008-09 and the subsequent euro-zone crisis highlighted the risks of investing in North America and Western Europe. The advanced countries had apparently come to offer an unattractive combination of high volatility and relatively low growth. Under such circumstances it is not surprising that emerging market equities, looking more attractive in comparison, recovered quickly from the turmoil of 2008.
In relation to the economy, the growth differential between the advanced and emerging economies seems to have narrowed (figure 2). It is particularly striking that this slowdown has happened during a relatively trouble-free period for the emerging world. China’s economic slowdown is an important part of the overall story. It has become commonplace to argue that China is in the midst of shift from investment-led, catch-up growth to a more sustainable phase of consumption-led expansion. However, there are additional internal and external factors behind the emerging world’s slowdown.
At a glance
• Emerging markets have come to play a much greater role in the world economy in recent decades.
• But developments in the advanced economies still have a profound influence on emerging markets.
• The outcome of China’s carefully engineered growth slowdown will be a key factor for emerging market investors to watch.
• Prospects for emerging markets vary more widely than ever in these difficult overall conditions.
What do we see when we probe more deeply into the record of emerging markets in recent years, and attempt to separate external factors from internal ones, and cyclical shifts from secular developments? What are all these shifts likely to mean for emerging market asset classes?
Developing economies certainly have substantially more weight than they did in the past – a shift that helps explain the discussion of their ‘decoupling’ from the advanced economies – but they are still influenced by developments in the West. If the advanced economies have problems, they will, one way or another, have a knock-on effect on emerging markets. The effect might not be as pronounced as in the past but it has not disappeared.
That helps explain why John Greenwood, chief economist at Invesco, sees the sluggish state of international trade as the key factor in the recent emerging market slowdown. “Global trade is static,” he says. Since many emerging economies have pursued export-led growth the weakness of trade flows has inevitably hit them. Maarten-Jan Bakkum, an emerging markets equity strategist at ING Investment Management, also highlights the poor state of global demand as a key factor in decelerating economic growth.
Over the past year and a half, the prospective monetary tightening in the West has also had a significant effect on emerging economies. Back in May 2013, many emerging markets suffered what became known as the ‘taper tantrum’ after Ben Bernanke, then chairman of the US Federal Reserve, hinted that a reduction in quantitative easing could be imminent. Both currencies and markets plummeted in some of the weaker emerging markets.
Overall, there is some disagreement among the experts, at least in terms of emphasis, on the likely impact of future monetary tightening in the West. For Michael Power, a strategist at Investec, “we are in a very dangerous part of the global cycle”. Those looking for extra liquidity to run their current account deficits could be in particular trouble.
Gregor Eder, an economist at Allianz, takes a similar view. With the end of tapering and uncertainty over the European Central Bank’s trajectory “we could see quite pronounced swings in capital flows in the short-term”, he warns.
In contrast, Greenwood does not anticipate a big sell-off. In his view the key question is whether there is a resumption of growth in the West. If rising rates coincide with an upturn in the West the negative impact should not be too great. The trouble could come if the central banks in the developed world raise rates prematurely.
Rahul Chadha, co-CIO at Mirae Asset Global Investments in Hong Kong, is also relatively sanguine on this question. “Early tightening is not that negative for markets,” he says. To the extent it does have an impact it is more likely to be on dollar-denominated assets than those in euros or yen.
China has the unique distinction of being both by far the largest emerging market and an important external influence on other developing economies. The rise of China has played a considerable role in helping other emerging economies power ahead in recent years. Commodity exporters, in particular, have benefitted from feeding China’s insatiable appetite for raw materials in recent years.
It follows that both a slowdown within the Asian giant and a change in its growth model will have significant effects. What looks like an inevitable fall in China’s growth rate will stem the impetus for growth in other emerging economies. The key question here is how far it will fall. China’s switch to a more consumption-led growth model will also have a profound impact. Although its appetite for raw materials could be diminished, there could be rising demand for consumer goods.
Power highlights the unique character of China’s shift. “It is the only country where the slowdown was engineered by the authorities,” he says. The government also recognises that the character of growth needs to change. ING’s Bakkum points out the difficulty this poses for China’s leaders. “They can decide to build a new bridge or a new railway line but they cannot really force somebody to buy a new couch,” he says.
The key question is whether China will manage to pull off a soft landing or whether a hard landing is imminent. Most commentators seem upbeat about it managing an orderly slowdown but there are danger signs. In particular, the investment surge has led to a substantial debt build-up in some sectors. Power points out that the large state-owned enterprises are hugely leveraged. “If the economy continues to slow, those companies could find themselves in extreme difficulty,” he says.
Although emerging markets are highly prone to external forces, they do have a degree of control over their own circumstances. The situation varies from country to country but they do have significant policy tools at their disposal. For example, many bolstered state spending and eased monetary in response to the 2008-09 financial crisis. Today a key challenge for them is to reverse these stances.
The difficulties involved in reversing course first became apparent during the taper tantrum of May 2013. It soon became clear that some countries were better able to handle the change in gear than others. In August 2013, Morgan Stanley published a paper in which it dubbed some of the large vulnerable economies as the “fragile five” – Brazil, India, Indonesia, South Africa and Turkey. These were countries that had a combination of weaknesses including, in most cases, high inflation, large current account deficits, challenging capital-flow prospects and potentially weak growth.
It is possible to debate the inclusion of particular countries on this list but there is a more important general point here. The emerging markets are becoming more divergent in their prospects. Although substantial differences have always existed within the emerging world the internal rift seems to be widening.
For ING’s Bakkum it is more important than ever for emerging economies to pursue good policies in this difficult environment. “If pressure is increasing, you can immediately see the differences between countries that have done their homework and the others that haven’t,” he says. He cites Argentina and Brazil as prime examples of economies that are particularly vulnerable. In contrast, in his view both Mexico and Poland are in relatively good shape.
India is the only large emerging economy where sentiment has improved substantially in recent months. September’s Interim Economic Assessment from the Organisation for Economic Cooperation and Development, a think tank mainly representing rich countries, revised its GDP growth forecast for 2014 up to 5.7% compared with 4.9% in May. Many economists and asset managers have become more upbeat about the country’s prospects since the election of Narendra Modi’s government in May 2014. Inflation seems to be falling and it is hoped that bureaucratic bottlenecks will be removed. India is also one of the emerging markets that should benefit from falling commodity prices.
It is difficult to draw out practical conclusions for emerging market investment from such a complex picture. Any such exercise inevitably runs into severe problems of generalisation. According to the IMF’s definition there are currently 153 countries classified as emerging market and developing economies. Clearly, each will have its own story, despite any common themes. It should also be noted that there are significant differences between experts in their assessment of this transition.
Perhaps the one certainty is that the outlook between different emerging markets is more varied than ever. Beyond that, it is clear that the progress of China’s engineered slowdown and the pace of the West’s recovery will be important influences to monitor. If the advanced economies suffer the secular stagnation many experts fear, it will hit the growth potential for the emerging world.
A pension fund invests: Coal Pension Trustees
• Assets under management: £20bn
• Emerging market equities: 10.5% of total assets
• Emerging market debt: 6.5% of total assets
• Emerging market debt: Legal & General Investment (passive); BlueBay Asset Management; Stone Harbor Investment Partners
• Emerging market equities: shared between several managers, including BlackRock, Legal & General Investment Management, First State Investments, Genesis Investment Management, JOHambro, Vontobel Asset Management
IPE: At 17% of fund assets, you clearly believe in the emerging markets story. What sort of story do you think it is?
Stefan Dunatov, CIO, Coal Pension Trustees: “We’ve had an emerging markets exposure in the portfolio for many years, both equity and debt, and if you compare us with a traditional market-capitalisation benchmark of the world we are at or above the weighting for emerging market equities and debt.
“In general, we still think the theme is a good one, which we identify as the broadening of the middle class in non-developed markets, their growing share of financial market capitalisation, and the shift in the world’s economic centre of gravity south and east. There will be business cycles and other, more severe hiccups along the way, and sometimes these markets will become more or less fashionable, but the overall thesis remains a good one.”
IPE: A belief in the emerging middle class theme usually entails a positive attitude to local currency exposure. Is that true for your fund?
Stefan Dunatov: “Yes, our debt holding – which, by the way, is 40% passively-owned because we think that the market is now mature enough to justify that – is entirely local-currency. Our belief is that if you buy into the general thesis, then you will want to own the asset and the underlying currency exposure that comes with it. You either have to believe that the underlying currency exposure will help your long-term total returns as exchange rates converge as consumption grows and these economies become more services-oriented than goods-oriented, or you have to accept that it’s very difficult to forecast currency returns. But you can only take that view if you consciously take the position of a multi-cycle investor. Taking emerging currency risk is a long-term play and simply doesn’t work if you only look forward two or three years.”
IPE: Indeed, it is through the currencies that the recent volatility in response to the prospect of diminishing US dollar liquidity around the world expressed itself. How concerned are you about the idea that emerging markets have been one of the favoured ‘carry trades’ of the past few years, and might be about to de-rate significantly as interest rates start to climb?
Stefan Dunatov: “There may be times when emerging market assets get very expensive or very cheap and you should not preclude yourself from acting in those circumstances – we would re-assess our allocation in that situation. But I think you have to have a longer-term view here than you do, perhaps, in some other parts of the portfolio.
“The impact of the US dollar might be problematic in the very short run, as we saw through the ‘taper tantrum’, but it should not be a big problem in the very long run. In many ways, I think these bouts of volatility reflect the market’s uncertainty about how to respond to a very, very unusual environment of zero interest rates, as opposed to the market knowing that emerging market equity and debt should be re-priced downwards because of imminent rate rises.”
IPE: Your bond portfolio is entirely sovereign exposure at the moment. Have you considered emerging market corporate debt?
Stefan Dunatov: “The corporate bond market is interesting and developing fast, and we have been talking about it with people. But the thing that holds us back at the moment is that, if you believe in the emerging middle class consumer theme, then the companies that are most likely to issue bonds are not necessarily the ones that you are seeking out. They are often already global companies, and because they have large proportion of their revenues in dollars they will probably be issuing debt in dollars, too. As always, the question is what sort of exposure you need to realise the investment thesis. If the thesis is the emerging consumer, owning Nestlé might be a better expression of that than owning Petrobras.”
Interview by Martin Steward
Under such circumstances, it is probably not surprising that many emerging market specialists sound cautious at present. ING’s Bakkum is guarded about all the main emerging market asset assets including debt, equity and indeed currencies. “Overall the picture is not a very good environment for emerging markets,” he says. At present, he believes local currency emerging market bonds probably offer the best value.
Investec’s Power is similarly reticent. “At the moment my view is that we need to be extraordinarily cautious about equities, bonds and currencies,” he says.
Gregor Eder from Allianz is, in contrast, more upbeat. Although economic growth has slowed significantly, he says the catch-up process is still intact. “It is less impressive than it was before but there are still lots of opportunities for asset managers”.
It may be a truism but in the new emerging market landscape the onus will be on asset managers to be more selective. The overall dynamic to growth may not be as vibrant as in recent decades but in such a varied landscape there should be opportunities to be found.
Special Report - Emerging Markets: Buying opportunity, or structural setback?
- Currently reading
Special Report - Emerging Markets: Emerging markets in transition