Sunday, July 8, 2012

A Brief Foray Into Emerging Markets

When scanning business headlines over the past week, two items of relevance were the lowering of key lending rates by the Chinese Central Bank (PBOC) in an attempt to counteract the country’s slowing growth, and the decline of two major emerging market currencies: India’s Rupee and the Brazilian Real. These stories serve as a reminder that there are themes of consequence moving markets other than the chronic Eurozone debt crisis. Then again, in the interconnected global economy, these are linked given that Europe is China’s largest export market and, lest we forget, it was growth from key emerging markets that buttressed the world economy during the depths of the (developed markets induced) financial crisis and ensuing recession.  

And so with this segue, we make our initial foray into the subject of emerging markets (EM). As the subject is clearly too broad to attack in one entry, the focus of this pass will be from an investment perspective. We’ll save for another day an examination of EM’s impact on the real economy, including the effect that Asia’s cheap labor force had on developed market prices (it kept a lid on them) and the influence these countries’ hunger for U.S. fixed income instruments had on lending rates, including those for mortgages (it…among other factors…contributed to downward pressure on them). And we know what that led to.
Where’s the Growth? Found it!

Historically investing in developing economies was fraught with risk and thus was relegated to a small allocation of institutional investors’ portfolios. Over the past two decades, though, these markets have adapted rules leading to increased transparency and stronger investor protection.  Financial market reforms have coincided with broader economic initiatives that have catalyzed growth in several previously struggling regions. And it is that reason…growth…that is perhaps the most compelling motivation for investors to consider exposure to EMs. Over the past ten years, annual GDP in the Eurozone and the U.S. has averaged 1.1% and 1.6%, respectively. During the same period, EMs have grown at a 6.5% annual clip. Over time, corporate earnings tend to track GDP growth. With advanced economies stuck in low gear, money managers must seek higher yielding investments. As seen in the chart below, over the same 10-year period, robust EM output has been reflected in equity returns, with the broad MSCI EM index far outpacing advanced economies and not taking the beating that the more established markets did during the depths of the financial crisis.

Historically this had not been the case. As the investor’s adage goes: “when America sneezes, the rest of the world catches a cold.” Put another way, given the dominance of the U.S. economy, when it slows, all other regions are negatively impacted, including financial markets, which see investors run from anything considered a high-risk investment. This brings up another common phrase: “in a crisis, the only thing that rises is correlation.” EMs relatively good performance during the recent turmoil is attributable to the fact that the crisis started in America and that many emerging countries had sufficient firepower to make up for diminished export demand by funding stimulus initiatives such as infrastructure projects and favorable tax treatment of domestic consumption like durable goods purchases.
The disparity in growth between emerging and advanced economies is expected to continue in decades to come. A recent study by Goldman Sachs estimated that over the next 20 years, annual GDP growth in emerging markets will average 6.7% while developed markets tread water at 1.8%. The same report projects at the market capitalization of emerging markets to grow at an annual clip of 9.3% over this period as developed markets’ equity capitalization will rise by only 4% annually (CAGR). The rapid growth in EM market cap will be partly attributable to appreciation while the remainder is a product of new issuance as these regions (theoretically) cut back on state-control of industry (something Greece should take to heart) and entrepreneurial enterprises gain a foothold. The expected divergence between EM and DM growth rates has significant ramifications for investors, such as pension funds, who must achieve a minimum rate of return to meet future obligations. Already institutional investors are dialing up their allocation to high-growth markets. Eventually other pools of capital, including high net worth individuals (already somewhat a factor in EM investing) and even broader retail investors will have to design ways to gain exposure to these regions if they want to enjoy the returns that developed markets had previously been able to deliver.

Impressive EM growth rates are not occurring by accident. A key driver is superior demographics. These are already large markets with rapidly growing populations, especially when compared to certain advanced economies like Japan and Western Europe. Not only are populations surging, they are also, for the first time, becoming increasingly urban and joining the middle class. This ties into a favored investment theme of increased EM domestic consumption for everything from higher protein diets and automobiles to creature comforts like home appliances, electronics and travel. Just under one half of China’s population are urban dwellers and personal consumption accounts for less than 40% of GDP (compared to 70% for the U.S.). Both of these figures are expected to rise in coming years. Other growth drivers include improving workforce productivity, the manufacture of higher margin, value-added goods (where do you think the beloved iPhone is made?) and an increasing use of leverage in the corporate sector to goose return on equity.
Not All EMs Created Equally

Not all of the aforementioned drivers are occurring in each county, nor are they progressing at the same pace. Emerging markets are a heterogeneous group. Often hot investment themes are applied with a broad brush, and slick marketing by purveyors of investment products doesn’t do justice to the nuances present in specific markets. In addition to varying levels of key EM drivers, markets also differ on issues like transparency, liquidity, the role of the state (as regulator or majority shareholder in key industries), taxation, shareholder/property rights, etc. Historically these potential red flags are the reasons why EM investments have commanded substantial risk premiums vis-à-vis advanced economies.

The headliner of EM investing has been the so-called BRIC (Brazil, Russia, India, & China) countries. More than just a marketing slogan by Goldman Sachs, which coined the term, these countries have been lumped together due to their large populations (including the world’s two largest countries) and impressive growth rates. But even within this group there is significant variation that warrants investor scrutiny. Two are democracies. Two are totalitarian (a fact that the Kremlin barely even attempts to conceal now). Two are export juggernauts, with Russia pumping out energy products and Brazil being a world leader in agricultural exports as well as iron ore. And two have been successful in leveraging their low cost (and increasingly higher skilled) workforces to fuel their rise to the top league of global players.
With the BRICs having been on investors’ radars for the past decade, attention has moved to other countries which show similar promise. Goldman hatched a new moniker called the Next 11 (N-11), an attempt to categorize a group even more varied than the BRICS. Other firms push exposure to the nebulous sounding Frontier Markets. Given the first word’s association with the wild west, these are likely opaque as mud and whose main participants are cronies of the ruling junta looking to monetize ill-gotten enterprises by pawning them off on foreign investors who did not do their homework.  And yes, there are plenty of investors who fit that description: namely ones who were kicking themselves for missing out on the initial phase of BRIC and Central European growth and wanted to get into the EM game regardless of the destination. Lesson: do your due diligence.

This is not to say that the ripest fruit on the EM tree has been picked. As with any asset class, there are fluctuations, which present attractive entry levels. As noted earlier, India’s main index is 8% off its 52-week high, while Brazil’s market is down 18%. The sour mood is reflected in each of these countries’ respective currencies being over 20% off recent peaks. The table below highlights what makes the BRICS attractive. It also includes other large emerging markets that are not far behind. In addition to favorable growth rates and government finances, many of the countries run current account surpluses (or small deficits) thanks to robust exports. On the flipside, the albatross of elevated inflation often accompanies rapid economic growth.  Inflation is not an investor’s friend, especially in markets where central banks have historically failed to effectively manage price levels.

An Investor’s Perspective

Early in the last decade, EM investing was left to sophisticated institutional investors and specialized funds. Impressive economic and investment performance broadened their appeal, and avenues in which to gain exposure increased. Many investors were attracted by the concept of decoupling, meaning that EMs had reached a self-sustaining level of growth (thanks to domestic consumption, infrastructure spending and piles of foreign reserves) to weather a recession emanating from developed markets. Alas that was not the case as the depth of the crisis sent shockwaves throughout the global economy. Although growth in EMs was not as hammered as that in advance economies, their financial markets saw severe drops as investors shed any asset with a hint of risk.  As a consequence, EMs still caught a cold from America.  Now that the dust has settled, as evidenced by consistent flows into international equity funds (at the expense of U.S. equities), investors are returning. Several lessons have been learned in the interim. Given the uniqueness of individual markets, investors can no longer apply the top-down brush. Instead they must conduct granular bottom-up analysis to identify the specific regions…and enterprises…that offer the most attractive risk-adjusted returns. Investors must take heed of yet another maxim (we have many of them), which is “never pay for beta.” All of these markets are growing. One need not pay elevated expenses to access general market growth. Reserve the fees for funds that have a track record of delivering returns in excess of markets. Historically, EMs have been fertile ground of uncovering such returns, but as a great number of investors cast an eye towards them, those opportunities naturally diminish.
This page is not in the business of parceling investment advice. It is sufficient to say that in the future there will be a growing assortment of choices to gain exposure to EM-related themes. In addition to funds investing directly into foreign markets, investors can choose U.S.-listed American Depository Receipts (ADRs) of some of the emerging world’s blue chip companies. By the week, the choices of ETFs seem to grow. And advanced-economy investors have the added benefit of investing directly into domestic firms that derive a significant amount of their revenues from EM customers. Chinese manufacturers require U.S. made machinery and specialized software. EM consumers aspire to buy Volkswagens and Toyotas (many of which are assembled in EMs), not to mention much sought-after European luxury goods. As slow developed market growth forces investors to seek alternative sources of sufficient yields, emerging financial markets will be forced to improve their regulatory framework, transparency and legal protections. This in turn should contribute to great volume and liquidity in these markets, which as a consequence, should lower volatility, yet another historical bugaboo of EM investing.

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