Driving global growth

Emerging markets in Latin America and Asia ex Japan could offer better growth prospects at less risk than developed markets, as the decoupling between developed and emerging economies materialises. Trend GDP growth in India and China is 7-8 per cent per year, for example, compared with an average 2-3 per cent per year in developed countries. But economic growth is compelling not only in China and India but also Indonesia, Turkey, Brazil and Russia, which all look well positioned for several years owing to their current account surpluses and huge foreign exchange reserves. Reevaluating risk “Most risk is in the developed world,” argues Jerome Booth, head of research at Ashmore. “Emerging markets have been able to avoid the deleveraging process facing developed economies, where risks include default risk and currency devaluation, and are not priced in. Non-performing loans, for example, will be an estimated 15-20 per cent in the developed world, compared with high single digits in emerging markets, as the deleveraging process works through,” he explains. “We need to completely rethink what risk is,” continues Mr Booth. “The new reality investors must get their heads around is that they should invest in emerging markets to reduce risk. Asset allocation should more closely reflect GDP weightings, otherwise investors will end up with a systematic bias to the developed world. Emerging markets already account for 35 per cent of GDP, and 50 per cent at purchasing power parity,” he adds. “A five-year cycle of sub-par growth is the best possible scenario in developed markets,” he believes. “IMF [International Monetary Fund] research based on 75 financial crises in recent history suggests that, on average, the deleveraging process takes five years to work through.” Back in the Great Depression, for example, it was not until 1941 that industrial production recovered to 1928 levels. In contrast, latent demand from consumers in emerging markets is huge. The growth in car consumption in China is 30 per cent annualised year on year, while mobile phone penetration is still only 30 per cent compared with 120-130 per cent in Europe. In Nigeria, the volume of beer sales has grown 10 per cent, meaning Nigerians drink more Guinness than the Irish. “A second key strength of emerging markets is that so much of the world’s oil and gas reserves are in the Middle East, the west coast of Africa, and Russia,” explains Nick Price, portfolio manager at Fidelity. “The consumption of oil per head in the US is 25 barrels a year, compared with 15-16 barrels in the UK, Japan and Europe, and under 2 barrels per head in China and India.” China and India are home to 2.3bn people so the impact of a catch-up in oil demand will be immense. “I’m not saying go and buy oil and gas stocks but I have a predisposition to consumer-related names in affected markets, such as banking stocks in Russia and Nigeria,” he adds. Emerging markets are already rich in globally competitive companies. Russian steel companies, such as Mechel and Severstar, produce steel for $150 per tonne compared with $500-525 at western counterparts such as Corus and British Steel. Qatar Industries pays less than one tenth than its western peers for gas, a key input to its nitrogen fertiliser. The competitiveness of Asian manufacturing is well documented. Mr Price says a Turkish auto assembler recently gave the Fidelity team a presentation demonstrating that a German auto assembler earns E45 per hour including benefits such as pension, compared with E1-2 for the equivalent Chinese worker and E4 for a Romanian. Historical precedent “Longer-term investors, particularly multi-generation investors, should view investing in emerging markets as similar to investing in the industrial revolution 200 years ago,” says Brian O’Reilly, head of wealth management research at UBS. “But emerging markets remain more risky than developed markets, and investors should keep this in mind, and assess their own tolerance for risk accordingly. As with all fast growing nations, such as Britain in the 19th century, when economies grow at these fast rates, the biggest risk to their growth is that inflation will get out of control and potentially hinder their development.” The twin crises that beset emerging markets in the past, currency crises and the flight of capital, look less likely today however. Most nations are in a better position regarding foreign currency reserves, and their dependency on foreign capital has diminished. “They have better balance sheets at individual and country level and the increasing urbanisation of the workforce is a spur to productivity as people come together,” says Paul Gibney, partner in the investment practice at Lane Clark & Peacock. Workforces across Asia have become highly skilled. China, for instance, has twice as many university graduates as the US, according to a Unesco report. The developing world’s propensity to innovate is demonstrated by the huge rise in patent applications across these regions. By 2006 patent applications from South Korea, China, and Russia made up nearly 20 per cent of those across the globe, according to the World Intellectual Property Organisation. “Very often our clients are underrepresented in emerging market equities,” Mr Gibney notes. “But it is worth pointing out that the World Order was very different in centuries past. If you look at the 18th and 19th centuries, a large proportion of global GDP related to emerging economies and the US itself only emerged in the 19th century. My point is that these things are not immutable.” An analysis of the long-term composition of world GDP carried out by Angus Maddison at the University of Groningen shows that trade in the nineteenth century was dominated by China and India. China was the world’s largest economy accounting for 30 per cent of global GDP while a century earlier India was probably the largest with 25 per cent of GDP. Value still to be found In the short-term, China has suffered a correction of 17 per cent since the start of August, and economies that still have a large export market could be vulnerable to further downdrafts. Compared with western economies, however, the consensus is that many emerging markets still offer good value. “Investors looking for a pull-back, given strength since the March lows, may very well find a better entry point, but we recommend that investors put money to work incrementally,” says Mr O’Reilly. “We continue to see headlines about bubbles, particularly in the closed domestic Chinese stock market, or the A shares, but for overseas investors the Hong Kong traded H shares, which give good exposure to China, are not particularly expensive. Currently they’re not trading at any significant premium to the developed market despite their faster growth rates, and investors may want to take advantage of this.” “On balance there is no reason for the double digit discount in many of these markets,” adds Wim-Hein Pals, manager of the Robeco emerging markets fund. “In Russia, for example, oil majors are at half the valuation of western oil groups. A 50 per cent discount taking into account political discord is way overblown. The situation has moved on from last year when we were in the middle of the Georgian war and Lehman had collapsed. Twelve months on it looks much more stable from a political and economic viewpoint,” he explains. Others are not quite so bullish. “Emerging markets are likely to see some profit taking, given that they have risen substantially since the start of the year,” cautions Devan Kaloo, head of global emerging markets, at Aberdeen. “We view any such correction as healthy. At the economic and corporate levels, there is little support for the speed with which markets have rallied. Indeed, conditions will likely be challenging for some time. Private spending is still anaemic, despite improvements elsewhere,” he explains. The best funds have seen substantial inflows, not only from investors rebalancing away from the developed world, but accelerated inflows from pension funds over the last three years which should prove sticky. Any increased impetus in the trend for investors to increase their allocations to emerging markets will also lift markets higher. As understanding of these markets grows, investors are moving beyond the simple desire to obtain blanket exposure to more specialist active and segmented strategies. “Stocks are no longer as cheap as they were so we are leaning towards active managers who can generate alpha and are even choosing between various countries in these regions,” says Dean Turner, equity strategist at Barclays Wealth.