Over the past 25 years there has been a sizeable shift in world market capitalisation – away from the traditional developed markets such as the United States, Europe and Japan towards the rapidly-growing emerging markets.
This shift is vividly reflected in MSCI All-Countries World index. In 1987, just 1 per cent of its weighting was in emerging markets; by 2007, the proportion had grown to 11 per cent. Growth rates in the emerging economies continue to outstrip their developed-market counterparts; some commentators predict that within the next decade some emerging market economies will have become bigger than many in the developed world. This should ultimately be reflected in terms of their stock market capitalisations.
Intuitively, one would expect emerging markets to continue to be the engine of global growth. While the developed markets’ labour force is set to grow by just two million in the next 20 years, those of the so-called BRIC countries (Brazil, Russia, India and China) are forecast to grow by more than 250m (see figure 1).
Investors need to start to adapt to this new reality. Yet, as the events of the past few months have illustrated, doing so requires nerve and imagination. In a bear market scenario such as the one we are experiencing, emerging markets are vulnerable to macroeconomic factors: exchange rate fluctuations, volatility in commodity prices, political turmoil, and speculative panics, as the past year has illustrated so dramatically.
Emerging markets were not alone in suffering a significant setback as the credit crunch began to take hold. Increased risk aversion meant investors flooded out of riskier investments into the relative safety of government bonds. Decoupling – the proposition that emerging markets were becoming largely immune to shifts in the developed economy – looked all but dead in the water.
Was the shift overdone? The recent resurgence in emerging markets seems to indicate it was. Perhaps the notion that the emerging world is much more export-orientated than its developed counterpart has been overstated – that, in fact, emerging “beta” is lower than is commonly perceived. Despite a huge reduction in global trade, markets such as China continue to grow much more quickly than the rest of the global economy.
However, the emerging-markets universe is anything but homogeneous; apart from China, one of the world’s major consumers of raw materials, it also includes countries whose economies are driven by the production of commodities such as Brazil, Russia and Chile. What unites them all is their superior rates of growth relative to developed countries. That makes an allocation to these markets increasingly important.
The fundamental factors underpinning emerging markets’ success remain in place. The asset class generally has strong foreign exchange reserves, low corporate debt and high household savings. There is also a clear trend towards urbanisation in the developing world, driving infrastructure programmes. Back in 1971, just one-fifth of India’s population lived in towns and cities. By 2016, that proportion is expected to have doubled (see figure 2).
These massive amounts being spent on infrastructure are helping to refocus demand towards domestic, rather than foreign, economies. Could it be that emerging markets are, after all, in a much stronger position to withstand the current setbacks to global growth?
The sharp upswing in the fortunes of emerging markets is welcome. At the same time, it serves to underline that the potentially spectacular rewards from the asset class carry big risks: namely, their vulnerability to a variety of macroeconomic factors.
At SWIP, we are bottom-up investors; we focus on how a company generates its cash earnings, and on how these earnings will grow. We believe superior performance can be achieved by actively managing portfolios constructed exclusively from stocks where the underlying company’s longer-term growth prospects are not reflected in its current stock price. By understanding how a company generates its earnings and carefully forecasting how these will grow over the long term, we believe we can identify a firm’s inherent value.
However, investors in emerging markets cannot ignore the particular forces that macroeconomic factors exert on emerging market companies. Emerging-market movements can be heavily influenced by flows of liquidity in and out of the asset class, and in extreme conditions such as those witnessed over the latter part of 2008, fundamentals tend to be ignored. Economic policies and macroeconomic statistics take on an enormous significance – indeed, sometimes it seems the macro elements are all the market cares about.
Our investment approach makes allowance for the importance of macroeconomic factors, and we view macro as a source of risk rather than a source of alpha. Political (in)stability, currency volatility, commodity prices or economic policies all must be taken into account.
