The last few years have seen an upsurge of interest in the theme of the so-called “emerging markets” (EM). For most of the past decade, sentiment towards EM has been generally bullish, but there are moments when perceived excessive euphoria leads to talk of “bubbles” and the like. This happened to some degree ahead of the first Fed rate hike in 2004, and it happened much more dramatically in the aftermath of the global financial crisis of 2008.
This year, the combination of unrest in the Middle East and worries about the impact of commodity price-driven inflation have led to the underperformance of EM versus developed markets (DM) amid renewed talk of bubbles. Now, while it is only natural for asset managers to focus on asset prices, focus must instead be on the tectonic shifts that have occurred in the world over the last decade. These epochal changes underpin the importance of EM to the global economy and global investment strategies.
The single undeniable fact about EM is that they already account for a significant portion of the world economy. According to the World Bank, as of the end of 2009, all EM accounted for about 38% of global GDP as measured at current nominal exchange rates. That percentage is probably closer to 40% by now. However, when considered by Purchasing Power Parity (PPP), the share of GDP by EM is even larger. As of October 2010, the IMF put the emerging markets share of global output at 50% at PPP. (In keeping with the convention of FX markets, the newly industrialised Asian economies will be considered, including Korea, Taiwan and Singapore, to be EM countries.)
There are two obvious conclusions from this. The first is that an investment strategy that is focused solely on the developing markets makes about as much sense as an advertising strategy for toothpaste that is focused only on one sex. It might do for a niche producer, but not for anyone with a genuinely global vision. The second point is that we, as foreign exchange traders, tend to be wary of PPP as a trading tool. Nevertheless, we believe that the 10% spread between the global weight of EM as measured in PPP terms and in current dollar terms will close over time – in other words, that emerging markets currencies as a group will outperform.
Strong growth and strong balance sheets
However, from the point of view of investors, what matters even more than the current importance of emerging markets is the likely scale of their future outperformance. That EM can be expected to outperform in terms of their growth outlook is not surprising. Countries that have embarked on “catching up” might well be expected to grow more strongly, and this has indeed been the case. What is more striking, however, is how superior the balance sheets of emerging markets are to those of developed markets. For those who remember the tumultuous decades of the 1980s and 1990s when emerging markets were plunged periodically into crisis by fiscal or current account imbalances, this is a remarkable turnaround. While there are pockets of vulnerability, the good health of emerging markets in aggregate is very clear, particularly when compared with the poor health of the developed markets. Attached are tables that show the broad indicators of growth, fiscal and current account indicators for a broad range of countries below, but even just the aggregate numbers are striking.
According to the IMF, in 2011 advanced economies are expected to grow by 2.2%, while the emerging economies are projected to grow by 6.4%. These growth differentials might not be surprising, but the scale of EM outperformance is still noteworthy. What is even more extraordinary is simply how much better EM balance sheets are, both in terms of stocks as well as flows. According to the IMF fiscal monitor published in November 2010, the gross general government debt/GDP ratio of the G7 economies will be 122.5% in 2015. Against this, the EM members of the G20 are expected to post a gross debt/GDP ratio of 32.7% in 2015. Insofar as a key component of debt sustainability is the cyclically adjusted primary balance (the gap between revenues and non-interest expenditures abstracting from short term developments in the business cycle), it is hardly surprising that developed markets come off as poorly as they do. According to the IMF fiscal monitor, the underlying primary deficit of the G7 economies in 2011 will be –5.9%. For the emerging members of the G20, it will be –1.2%.
The picture that emerges from these statistics is clear and disturbing. The developed world in aggregate entered into the crisis with an excess of leverage and lower growth rates than the emerging markets. Indeed, the excessive leverage might itself have been the result of a desire to shield citizens (and their consumption prospects) from the consequences of a structural decline in growth rates. To put it in financial terms, excessive leverage was a way to maintain constant return on equity at a time when the return on assets was falling. Whatever the reason, large portions of the developed world (particularly the US, the UK and the periphery of the Euro zone) face a future of continued deleveraging that will put pressure on growth and be reflected in a recovery that is weak by historical standards. Conversely, the emerging markets in aggregate will face less pressure from deleveraging and consequently can enjoy higher growth. Higher growth in turn translates into lower countercyclical fiscal outlays as well as reduced pressure of deflation. Together, these factors imply less pressure on private and public balance sheets. For the emerging markets then, the interaction among growth and balance sheets forms a self reinforcing virtuous circle.
The implications of this virtuous circle may be gleaned from a fascinating publication issued by Standard Chartered Bank entitled “The Super Cycle Report”, according to which 68% of the world’s growth until 2030 will come from the emerging markets. According to the same report, in nominal terms, today’s emerging markets will account for about 65% of world nominal GDP by that date (up from about 40% now). Global GDP is expected to at least double in real terms and to quintuple in nominal terms by that date.
Implications for asset markets
If this is indeed the case, what are the implications across asset classes? If nothing else, it suggests that ignoring the emerging markets as just a fashionable fad would be little short of investment folly. To reiterate, this is a universe that comprises one half of world GDP (at PPP) today and is expected to provide about two-thirds of global growth over the next two decades. Even today, the impact of the emerging markets on world asset markets is immense – this is particularly evident in the commodity markets, but it is also true of foreign exchange markets, where the emerging world’s reserve banks and sovereign wealth funds are key players. This impact can only be expected to grow.
In terms of allocation decisions between developed and emerging markets, we would suggest that the higher growth and stronger balance sheet positions of EM have important consequences. The relatively strong fiscal positions of emerging markets (and the corresponding deterioration of fiscal positions in the core of the developed world) suggest that the notion of risky and risk-free assets might need to be reconsidered. Meanwhile, the combination of higher trend growth rates and a significantly lower threat of a debt-deflationary spiral is likely to result in higher equilibrium interest rates in EM. The combination of higher interest rates and reduced fiscal risk premia argue for increased participation in local currency debt markets in EM. These factors also signal a potential for currency appreciation (which would also be justified by the undervaluation of EM in aggregate on the basis of PPP).
More generally, we would make the case that investors are very likely to be underallocated to fixed income assets in emerging local markets. This might be due to market restrictions or due to worries about taking on local currency risk. It might also reflect the greater liquidity of core developed world bond markets. However, it seems to us that this is an instance in which considerations of size mask deeper vulnerabilities. Liquidity is after all but a euphemism for supply. Simply put, larger and more liquid debt markets are a symptom of the greater indebtedness of the developed world.
Meanwhile, a recent piece of research from the McKinsey Global Institute entitled “Farewell to Cheap Capital” points out that the rising investment needs of the emerging markets could actually lead to a significant rise in global interest rates over the next two decades as the excess of global savings over global investment shrinks. In turn, this could exacerbate the problems of those portions of the developed world that have in the past “benefited” from abnormally low global interest rates and have channelled their command of those excess savings into unproductive assets.
Differentiating within the EM Universe
The case has been made above that emerging markets offer superior growth and balance sheet metrics to the developed markets. But as we pointed out, we are also speaking in aggregate. The question then becomes one of how to judge among different emerging markets. Rather than go through a list that evaluates every single country, we would rather lay out some of the criteria that we use to differentiate among different markets. At various times in the cycle, different factors might become more important in determining the attractiveness of one EM versus another, or one EM asset class versus another.
One basic criterion is to differentiate between closed and open economies. During the immediate aftermath of the crisis, it became clear that the large relatively closed quasi-continental economies like India and Indonesia enjoyed better growth than the very open economies like Singapore that were very susceptible to swings in developed world demand. Another obvious criterion for differentiation is that between current account deficit and current account surplus economies. Within the group of deficit economies, one ought to pay a lot of attention to the quality of current account financing – whether it is financed by relatively sticky direct investment flows or by relatively flighty portfolio flows. Exchange rate regimes and central bank reaction functions are important in all countries, but the credibility of the central bank is an especially important variable in countries that are dependent on portfolio capital to finance current account deficits.
The nature of the export mix is also a key variable in differentiating among countries. Insofar as the pattern of growth among EM is likely to be very commodity intensive (reflecting their desire to use their ample financial resources to build out more sophisticated physical infrastructure), there could be persistent upward pressure on commodity prices. This in turn translates into a positive terms of trade shock for emerging and developed commodity exporters. While the growth and currency implications for the exporters of commodities might be quite positive, the status of the commodity importers requires closer examination and interpretation. How will their central banks react to a shock from imported inflation? Are they current account surplus countries that can react to such a shock by reducing reserve accumulation and accommodating currency gains to fight inflation? If not, what is the willingness to sacrifice growth to maintain credibility in the fight against inflation?
After recent developments in the Middle East, considerations of political risk – which were once the paramount consideration in dealing with EM – have once again returned to centre stage. This is, of course, justified. In considering political risk, we would pay attention to factors such as institutional flexibility and legitimacy as well as the interaction between these institutional factors and economic outcomes, measured in both aggregate and distributional terms. In thinking through these political issues, we would argue that broad-based growth can allow governments to have degrees of policy freedom that are denied to those facing growth constraints or more straitened economic horizons. This is another dimension to keep in mind when comparing EM with today’s developed markets, where politics might actually become more intractable in response to more difficult economic circumstances.
How much room to grow?
A final question has to do with whether EM is capable of generating enough demand to make up for the potentially depressed spirits of the developed world consumer for some time to come. We do not deny the difficulty of reorienting economies towards domestic consumption (and this issue really applies primarily to China rather than to India, Indonesia or most of Latin America). But even in this case, the sheer scale of unmet needs suggests that any argument based on an absolute insufficiency of EM demand makes little sense. The research from Standard Chartered Bank points out that real per capita income in China today is roughly the same as real per capita income in the US in 1878, and real per capita income in India is one fourth that in China. More granular figures make this even clearer.
The statistics on motor vehicles (from the US department of energy) are roughly in line with the time scale suggested by the Standard Chartered research. As of 2008, the degree of motorisation in Brazil was comparable to that of the US in 1923, while the degree of motorisation of China and Indonesia was comparable to that of the US in 1917, and that of India to that of the US in 1913. This is an extraordinary divergence that has only just begun to close.
Of course, the emerging markets have always had these enormous needs. What is different today is that they have the financial capacity to meet these needs. And as they proceed down the path of faster development, the consequences for the world economy and world politics will be truly immense. Whatever else, the EM story simply cannot be ignored. The impact of emerging markets on patterns of global growth, commodity demand, inflation, interest rates, exchange rates and risk premia is already large and only going to get larger. Thus, knowledge of emerging markets trends is not going to be the concern solely of dedicated EM investors. A genuine global macro strategy has, by definition, to incorporate a deep consideration of the impact of emerging markets on every asset class in the world.
This article first appeared in swissHEDGE (1st Half 2011 Issue, Page 19 – 23). For more information, please visit www.swisshedgemagazine.ch.