Emerging markets: The new drivers of global growth

Times are definitely changing. Although emerging markets enthusiasts are always telling anyone who will listen these countries are where the future is, this time it looks like they might be right.

While economic growth in developed markets is only now starting to slowly recover from the battering it took during the global financial crisis (GFC), emerging markets have been powering ahead.

This divergence in performance looks set to continue into 2010, with Morgan Stanley predicting a 1.9 per cent gross domestic product (GDP) growth for the advanced G10 economies but 6.0 per cent for emerging economies.

Some emerging markets will do even better. The Morgan Stanley forecast has 2010 Chinese GDP growth at 10 per cent, India at 8.0 per cent, Russia at 5.3 per cent and Brazil growing 4.8 per cent.

This "tale of two worlds", as Morgan Stanley calls it, reflects some major structural changes in the global economy and underpins the arguments in favour of emerging market investments.

Many investors have already been lured by the better economic performance and outlook for emerging market economies, with the MSCI Emerging Markets Index rallying 73 per cent last year and developing nations taking the honours for the 10 best performing markets.

So the question now is whether the time for emerging markets has come and whether their strong run can continue.

Where to now?

Emerging markets guru Mark Mobius, the executive chairman of Templeton Asset Management, is one of the leading bulls on their prospects.

In a television interview with CNBC in late December, he says emerging markets still have the potential to rise further. "I am looking forward to a very good 2010, with of course corrections along the way," Mobius says.

HSBC Australia head of global investments Charles Genocchio agrees the outlook is positive.

"Emerging markets have gone up spectacularly this year. 2010 will be a year of consolidation for the developed world and more growth in emerging markets," he says.

To correctly assess the prospects for emerging markets, Aberdeen Asset Management senior investment specialist Stuart James believes investors need to consider the background to their recent stellar performance.

"The rally in 2009 started in 2008 when emerging markets were oversold and some of the rally is due to them being oversold. When people are risk averse, they sell off investments and tend to repatriate profits, which is what they did in 2008," he says.

Genocchio agrees much of last year’s big rally could be explained by the dramatic sell-off during the GFC.

"Emerging markets have had a spectacular comeback, but it is important to remember they had a spectacular decline to start with, and this means they came off a lower base than developed markets," he says.

Despite this, James believes emerging markets have a good chance of doing well this year.

"Emerging markets have come out of the crisis fairly well. The outlook is fairly positive, although they look fair value now rather than very cheap as they did at the beginning of 2008," he says.

This tallies with the view of Mobius, who claims emerging markets are currently at the middle of their valuation range.

"At a low point in the last 10 years it was one times book [value]. At the high point, it was three times the book value, now it’s about two times. So we are more or less in the middle of the valuation range," he said.

Looking at the fundamentals

Schroders’ UK-based head of emerging market equities, Allan Conway, is another who believes the emerging market rally still has legs.

"Despite the strong performance of emerging markets this year, we believe the rally has further to go," he says.

Even under a variety of economic scenarios, the Schroders economics team is predicting a good performance. "Under all of our scenarios, double-dip, V-shaped recovery or slump, we forecast that emerging economies will outperform developed economies," Conway says.

To support their positive view on emerging markets, the experts point to their better fundamentals compared to developed markets.

"If you look at emerging markets, they have no structural banking issues and they have trade surpluses and not too aggressive fiscal policies," Genocchio says.

"This makes them more attractive than developed markets, especially the US and UK."

Conway agrees with this assessment: "Economic fundamentals are much more robust in the emerging world, the prospects for earnings growth are very strong and emerging markets are trading at a discount to developed markets. These advantages, coupled with favourable liquidity conditions, add up to a very positive outlook for these markets on a 12 to 18-month view."

These conditions are in stark contrast to those in developed markets.

"Most emerging markets have net positive balance sheets. The structural problems are in developed markets," James says.

Genocchio agrees it is developed markets rather than emerging markets that face difficulties.

"Asian markets went through their banking crisis in 1997-98 and this scared people, but they have really fixed up their banking systems and they are now very strong," he says.

Who’s driving global growth?

Increasingly, economists around the world are highlighting the ebbing dominance of traditional developed markets when it comes to global economic growth.

"Investors are increasingly recognising the structural change that has occurred in the global economy – it is the emerging and not the developed economies that are now driving global growth," Conway says.

"Over the last 10 years emerging economies have strengthened and have moved up to growing 3 per cent to 5 per cent faster than the developed economies every single year. As a result, emerging markets’ share of global GDP growth has been increasing over time."

While the GFC may have made this trend more pronounced, economic recovery is unlikely to see it unwind.

"Even with a recovery in the developed world, emerging markets will account for 70 per cent to 75 per cent of global growth every year for the foreseeable future. This is a major structural change, certainly as significant as the Industrial Revolution in the 19th Century, perhaps more so," Conway said.

"In the past, the global economy was driven by the developed economies and emerging markets relied on developed world demand for their exports – the reverse is now the case."

According to HSBC’s Hong Kong-based senior Asia economist, Frederic Neumann, Australia’s economy is a good example of how a developed economy is now relying on an emerging market for its export market. In October 2009, China took over the position as Australia’s largest export market, highlighting the changing global economic pattern.

"The continued demand for raw materials from emerging markets will help underpin Australia’s ongoing export boom, providing a critical boost to the overall economy," Neumann says.

Demographics and demand

Another factor assisting emerging markets to become the key drivers of global economic growth is their youthful populations.

"This is a really important issue for emerging markets," Genocchio says.

"Demographics in emerging markets are so much more advantageous than in the developed world. There they need to increase taxes to pay for pensions and this is a great problem for Europe."

James agrees investors need to consider this issue when assessing the future growth prospects for emerging market companies.

"Four billion people around the world live in emerging markets and they tend to be very young populations, so they are the workers and consumers of the future," he says.

These demographics are creating strong internal markets in emerging markets, which is allowing them to slowly move away from their traditional reliance on exports – and the economic cycle in developed countries.

"In India, only 23 per cent of GDP is export focused, so it is not so influenced by global growth," James says.

There is also growing intra-regional trade flows, according to Conway.

"Trade between emerging economies is also becoming increasingly important. China now accounts for a larger share of exports from emerging markets than the US. China also exports more to emerging countries than it does to the whole of the G7," he says.

Dangers from abroad

Despite this lessening reliance on developed markets, they remain the most likely source of future problems for emerging markets.

"The problems will come from the developed world, not internal emerging market problems," Genocchio says.

James agrees external shocks are more likely to cause problems for emerging markets than internal factors and he admits there could be nasty surprises ahead.

"The global economy is not completely out of the woods yet. Greece and Eastern Europe have the potential to create problems. In Eastern Europe there are high debt levels and I would not be surprised if problems emerge from there this year," he says.

The dependence of developed market recovery on government stimulus packages also has the potential to create problems.

"In developed markets, the removal of the government stimulus will be very delicate and if something goes wrong, we could see a replay of 2008, when emerging markets were sold off due to problems in developed markets," James says.

"In 2010, developed markets are likely to have a really difficult time turning things into sustainable economic growth. It will not take much to disappoint the markets, so it will be a delicate balance."

Conway believes this is a real possibility. "We would not be surprised to see a setback in emerging markets, with the trigger for this likely to be the factoring in of a double-dip scenario for the global economy," he says.

However, the setback is unlikely to be more than 10 per cent to 15 per cent and "short and sharp, as investors are likely to buy on the dips".

Even the strength of Chinese growth has the potential to create problems, according to James.

"China has bounced back, but when you have stimulated the economy so much and ordered banks to lend, you are going to have payback from that level of stimulus," he warned.

However, he believes any market dips could provide good entry points for investors who recognise emerging markets are at least a five to seven-year investment.

"2010 may offer some good buying opportunities if there are problems in the markets," James says.

"Emerging markets are a long-term story, although there will be speed humps along the way."

Asian markets calling

For investors looking to take the plunge, there are several areas of opportunity within the emerging markets universe, although the Asian markets seem to be the top pick.

"We don’t like Eastern Europe, but when you look at Latin America and Eastern Asia, they are the most positive countries you can find," Genocchio says.

"I am a big fan of emerging Asia. Some of the valuations are getting high, but they are still attractive. You can access them through an Asian fund or an emerging market fund where the potential impact of problems in areas like Eastern Europe will be small."

Aberdeen takes a bottom up approach to its emerging markets portfolio and picks good companies with strong balance sheets, according to James. "It is easy to be seduced by the macro hype, but investing needs to be about good companies. You really need to know the company and be company focused."

When it comes to specific sectors, James is keen on domestically-based emerging market companies rather than exporters.

"We are overweight banks. Banks in emerging markets kept their noses clean during the crisis. They tend to be in countries with very high savings rates and fast rising incomes and they have a simple structure of earning a margin on deposits so they are easy to understand. It is very different to Western investment banks," he says.

Aberdeen is also keen on companies providing consumer staples such as Hindustan Unilever (the Indian subsidiary of Unilever) and Massmart in South Africa (the African version of Wal-Mart). The firm also has investments in Hero Honda, a joint venture between Honda and a major Indian manufacturer which is building a new scooter every 18 seconds.

James believes the key to emerging markets investing is to focus on the future. "The long-term story is rosy but there will be problems along the way."

Warning: currency trouble ahead?

While the prospects for emerging markets are generally positive, one area investors need to watch is exchange rates.

The decline in the US dollar is putting pressure on the currencies of many emerging market countries and making their exports less competitive.

Tensions are growing over the issue, with China increasingly in the firing line over its continuing policy of pegging its currency to the weak US dollar.

China’s export competitors are becoming concerned, according to HSBC Australia’s Charles Genocchio.

"A weak US dollar leads to a weak renminbi and this leads to the problem of China being too competitive for other emerging markets – especially Asian markets," he says.

Countries without currencies pegged to the US dollar, such as Brazil and Taiwan, have already taken steps to limit the damage.

"Some emerging market countries not linked to the US dollar have put foreign exchange controls in place as they are sick of having their currencies caught by the impact of the decline in the US dollar. It is killing their manufacturing sector," Genocchio says.

With the European Union’s new trade chief, Karel De Gucht, calling China’s policy of keeping its currency at a low level against the US dollar and the euro "a major problem", the question of exchange rates looks set to become a hotspot.

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* This article was first published in Money Management on February 1, 2010.

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