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.
