Whither Emerging Markets

Once an unquestioned investment favorite, emerging markets have given all a wild ride during the past few years and have generally disappointed. They could not help but do so given the expectations that had prevailed. Now, many of these markets are coming back, though China’s has suffered acutely of late. Interest in the area has risen accordingly, but people remain wary. That is probably healthy, though there is good reason to reconsider this asset class now. Emerging markets, of course, are no place for those who dislike volatility or those with a short-term investment horizon. But for the longer-term investor, things look favorable. These equity markets show value that should pay off, especially for those economies adjusting to the new global environment.

A Little Historical Perspective         

Just prior to the 2007-09 financial crises and great recession, consensus saw emerging economies as the place for universally rapid growth where equities would produce superior returns. China’s economy, for instance, had grown at 10-12 percent a year in real terms during the prior five years. India had shown real annual growth rates averaging near 9.0 percent during that time. Brazil had a much lower average growth of some 4.0 percent but showed individual years where real growth approached or exceeded 6.0 percent. China’s Shanghai Composite Index averaged price gains of 31.1 percent a year during the five years leading up to 2007’s pre-crisis peak. India’s SENSEX Index did even better, averaging 38.0 percent a year. Smaller markets did well, too. Indonesia’s JKSE Composit showed annual price gains of 45.2 percent, while Brazil’s Bovespa Index averaged 34.4 percent. And this is just a sampling. The pattern was widespread. Consensus wisdom viewed emerging economies as on track to grow at rapid rates and produce great equity returns indefinitely.

The crisis interrupted the pattern, but it seemed to return with the initial recovery of 2009. China’s economy, for example, grew 9.2 percent in real terms that year and India’s 8.5 percent. Brazil’s averaged a decline for the year, but more detailed quarterly and monthly figures pointed to strength. Similar growth spurts appeared throughout most of the emerging world. Their equity markets showed their old verve as well. Chinese stock prices rose almost 80 percent in 2009, India’s 81 percent, Indonesia’s 87 percent, and Brazil’s 73 percent. The attractive pattern was pretty consistent across the sector.

Disappointment set in after 2010. All these economies slowed, some very abruptly, and their equity markets underperformed accordingly. China’s real annual growth rate trended down to an annual pace of just above 7.0 percent by 2013. Its Shanghai stock composit averaged price declines of 9.2 percent a year during those four years. India’s economy grew at closer to a 5.5-6.5 percent rate during much of this period, barely over half its pre-crisis pace. Its SENSEX Stock Index saw an average annual price advance of under 5.0 percent. Brazil, under tremendous economic strain, barely escaped a relapse into recession and grew only about 2.0 percent a year from 2011 to 2013. Its equity market accordingly saw price gains of merely 2.3 percent a year. Indonesia, along with other oil-based economies, did better because of rising energy prices during that time. Even then, its equity market advance of 13.4 percent a year during this time paled in comparison to its pre-crisis performance.

It is now apparent, even to consensus thinking, that the great growth and equity gains of 2002-07 were far from fundamental. Instead, they arose from the confluence of near perfect conditions. Global trade at the time was growing much faster than the developed economies generally, providing opportunities for the export-oriented emerging economies, which, in one way or another, was just about all of them. Commodity prices, including oil, were rising, benefitting that not insignificant portion of emerging economies that depend on commodities exports. At the same time, developed countries kept their interest rates low, providing a free flow of global liquidity and effectively giving emerging markets an abundance of investment monies that not only benefitted their overall growth and productivity but that also supported their financial markets directly. And since many of these countries had liberalized their economies in the 1990s, they were perfectly positioned to realize all these special benefits.


If the future cannot promise this remarkable confluence of positives, emerging markets can nonetheless still make satisfactory gains. They certainly show relative value. Emerging market multiples stand on average 20 percent below U.S. equity multiples and 8-10 percent below those in Europe and Japan. On that basis alone, they should generate relatively good returns even in the absence of perfection. All they require is some slight improvement in the fundamentals that retarded performance in the 2009-13 period. And this is likely.

One such factor is policy. Tightening fiscal and monetary policies contributed much to the disappointing 2009-13 economic and market performances. Economic managers in these countries were not actively trying to slow growth during this time. The problem was that they had eased policy so much in 2008-09 to deal with the crisis that efforts to normalize things in recovery had the effect of restraint. Now that most of these policy adjustments have run their course, these economies should feel a sense of policy relief going forward, even if their economic managers simply adopt a neutral policy stance, though some, China most notably, have moved toward more stimulative policies for the time being. In part for this reason the International Monetary Fund (IMF) expects 5.2 percent annual real growth rates for emerging economies as a whole during the next five years, up from the 2009-14 period and notably twice as fast as its expectations for the United States and more than three times its expectations for the euro-zone or Japan.

Trade, too, should accelerate modestly. No one expects a return to the growth pace that prevailed before the crises, but neither should these economies suffer the shock that beset them in the years following the crisis, when every expectation of the time faced disappointment. On the contrary, the IMF actually expects a modest uptick in world trade in part because of the dollar’s recent strength but not exclusively for that reason. Such projections should, of course, be taken with more than a little salt, but it is indicative nonetheless that the IMF looks for emerging economy exports to accelerate from the 5.0 percent annual pace they averaged between 2009 and 2014 to 6.5 percent during the next few years. The projected growth pace is still slower than between 2002 and 2007 but is nonetheless a marked uptick from recent years, a 30 percent jump in fact.

Even the decision by the Federal Reserve (Fed) to notch back its monetary ease many not have the retarding effect some expect. To be sure, the Fed caused considerable concern among emerging market investors in 2013 when it announced its intention to taper off its quantitative easing program, though when it actually did the tapering these markets stood up reasonably well. Now the Fed plans to dry up still more excess dollar liquidity by raising interest rates gradually. By itself, this policy posture would tend to retard both growth in emerging economies and gains in their markets. But these actions are not happening by themselves. While the Fed is pulling back, both the European Central Bank (ECB) and the Bank of Japan have announced significant quantitative easing programs and have pushed interest rates down toward zero, into negative territory in some cases. Such new flows of liquidity should more than offset the Fed’s plans for dollar liquidity, allowing a continued robust expansion in global money flows over the next few years.

Ways to Discriminate Among Markets

Apart from these largely favorable general considerations, a number of other perspectives should help investors discriminate among emerging economies and markets. One is relative movements in the value of the dollar and the euro. Since the dollar will likely continue to rise against the euro, those that depend relative more on American markets and less on European markets would seem to have an advantage. This is, of course, no place to list all fifty-plus markets usually grouped in the asset class. Still, there are standouts. Latin America economies would seem to have the edge in this regard over the European emerging economies and those of the Middle East and North Africa. Asia offers a mixed picture. Of the economies often singled out in emerging markets discussions, China, India, Malaysia, and Vietnam would seem to have an advantage in this regard, while Russia, Turkey, and Egypt would seem to face a disadvantage.

The ongoing slowdown in Chinese growth would seem to disadvantage economies that count on China as a major market. That would include Africa, Central Asia, Russia, Vietnam, Indonesia, Malaysia, and, in Latin America, Chile and Argentina. Those with less of a problem in this regard include India, Europe’s emerging economies, and much of the rest of Latin America, except Brazil and to a lesser extent Mexico. Since the generally slow pace of growth globally, and particularly the slowdown in China, should keep a lid on commodity prices, those emerging economies that depend a lot on sales in this area would seem to face disadvantages relative to others. In this respect, the oil economies in Latin America, Africa, the Middle East, and Central Asia look less desirable, including Russia. In addition, Peru, Brazil, Thailand, Malaysia, Indonesia, and the Philippines face disadvantages, at least in this context. The European emerging markets face the least problem in this regard.

Longer term, the key to emerging economies and so to the best investment returns is their ability to make the fundamental structural changes demanded at each stage of development. In this respect, there are three key considerations to guide investment decisions. The first of these is the commitment of each economy to education and training. It in large part should determine that economy’s ability to leverage the technologies and the best practices of the developed economies. On this front, China, Singapore, Taiwan, and Hong Kong lead, as does India, though in a less comprehensive way. The European emerging economies score relatively high in this regard as well. A second support is each economy’s ability to receive these technologies and best practices. This requires an openness in both in trade and finance. Here the mix changes. Singapore, Hong Kong, Malaysia, Taiwan, and most of emerging Europe score high. Vietnam sores high on trade openness but low when it comes to finance. Sadly, frequently mentioned names in emerging markets discussions – Russia, China, Brazil, India, Mexico, Indonesia, and Turkey – all score poorly on questions of either trade or financial openness.

This discussion hardly answers all the questions about this investment class. That would take a book. Clearly, many markets that look good in one respect fall down in another. Some of the positives have a shorter-term nature than others. Three takeaways emerge from this mélange of considerations: (1) Circumstances, though not likely to return to the universally favorable environment of earlier this century, probably will support emerging market investments going forward, certainly better than in the 2009-13 period. (2) All these economies have tremendous development potential, if they will only open themselves to and put themselves in a position to leverage the technological and best practices on offer from the developed economies through trade and investments. (3) Except in rare cases, any single factor – favorable or unfavorable – will face balancing influences from other factors.

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