The financial media has perpetuated the idea of the ‘crisis’ in emerging markets; whether it is political turmoil in Ukraine, Thailand, Turkey, Venezuela or inflation in Brazil, all of these situations have frightened investors away. Each situation is different, but they also present many similarities. There is an Arabian proverb which reminds one that in every crisis there is an opportunity: “Four things come not back: the spoken word, the sped arrow, the past life, the neglected opportunity.” Before delving into an assessment of the right approach for global investment, it is important to take a general look at the emerging market hypothesis, which can be divided into the following elements:

• Higher than average GDP growth; young populations; urban migration. In effect the ‘demographic dividend’;
• Modernisation of infrastructure;
• Manufacturing excellence/efficiency driven by plant modernisation and lower labour costs;
• Wealth growth, which in turn leads to emerging consumer plays;
• Abundant natural resources.

These factors alone are not sufficient cause for investing. One must pay an attractive price for growth, and top-line growth on its own is not a guarantee of profit or positive investor returns.

Understanding the market
Today, an investment strategy towards emerging market (EM) equities should not be premised on the simplified thesis that all EM’s are in a synchronised expansion, where one can then make an allocation towards the BRIC countries (Brazil Russia, India, China) markets through an exchange-traded fund (ETF). The term ‘BRIC’ was first coined 13 years ago, and that label brought global investor attention. Financial product innovators immediately created BRIC asset allocation products and soon Western capital flooded into these markets, propelling them up at rates five to 10 times higher than the US equity markets from 2002-08. The Emerging Asia index went up by five times in that period; the Emerging Eastern Europe index by eight times; and the Emerging Latin America index was up 10 times. Over the same period, the S&P 500 rose by 85 percent. Since the meltdown in 2008, these markets fell twice that of the S&P 500 and since then the US market has bounced back to its old 2008 highs, whereas each one of these broader BRIC EM indices are still materially below their pre-crash high.

Unlike in the past, when almost all emerging markets were on a synchronised expansion, things are much
different today

Unlike in the past, when almost all emerging markets were on a synchronised expansion, things are much different today. Many emerging economies are now running trade account deficits, have overleveraged banking systems, declining profit margins, currency devaluations, inflation pressures and social unrest. Other countries, like the UAE, are on the rise economically and their stock market performance reflects this acceleration. This phenomenon emphasises the notion that country or regional selection (and stock selection) is likely to be much more important to success than the old approach of selecting an EM basket in one’s portfolio.

Emerging markets clearly contain more volatility than their developed market counterparts. Previous crises in EMs led to long-standing problems, while impacts on developed equity markets were much more temporary.

There are fundamental reasons why it takes some time for these markets to become attractive buys. There are two distinct but interrelated metrics to understand. One is the trade dependency of a country, and second is its capital market dependency with the rest of the world. What brings these two factors together is a country’s trade deficit, or surplus. Countries with a trade deficit basically need to finance that deficit; in short they are capital importers. If a country’s imports are valued greater than its exports, a trade deficit develops. If the deficit persists, the currency eventually ‘devalues’ as a mechanism to slow the imports and accelerate exports. Countries with dependence on imported food and or fuel for example are particularly vulnerable. As their local currency depreciates it costs more to import food and fuel and this leads to inflationary pressure and then social unrest. Basic sustenance becomes very expensive for the local population.

Furthermore, the inability of a country to pay for government services like police and fire protection creates additional local political risk. This is exactly what happened in Ukraine, Thailand and Turkey. Economic stress highlights political mismanagement and inefficiency leading to a populist request for new leadership or reforms. Policymakers in these countries have many agendas, but most want to maintain their control. They attempt to fight currency depreciation and local inflation by raising interest rates or placing restrictions on the exodus of local capital. This becomes another contributor to social unrest (rising costs of mortgages) and then, coupled with inflation, social unrest leads to a period of poor relative and absolute returns for local equity markets. These issues are ones that take many months to rebalance. Early re-entry to these markets based on comparisons to historic valuations can be value traps.

Crisis spillover
Because many of these economies compete with one another for capital and for exporting power, countries that are similarly situated with trade deficits usually have capital markets that are correlated. When there is a ‘crisis’ in one, it usually leads to some systematic risk across other similarly situated country’s currencies and equity and fixed income markets.

For some time now, there has been growing concern about five emerging markets in particular: Turkey, Brazil, South Africa, India and Indonesia, referred to as the ‘fragile five’. The argument goes that these markets exhibit current account and fiscal deficits and are particularly vulnerable to US Federal Reserve tapering and investor confidence. Earlier this year, global markets sold off on this systematic anxiety. Similar to Greece or Ireland, these economies represent less than five percent of world GDP, and only about 0.5 percent of world equity market capitalisation. In our opinion, the ‘fragile five crisis’ is likely to only be a tempest in the teapot, and is not likely to affect in a material way the rest of the world’s economies.

China, on the other hand, is a significant player in the world economy; it’s not the tempest in the teapot, it is the teapot. Deceleration risk in China is likely to have a material effect on the second tier emerging market economies that are suppliers to China, whether it is raw materials or energy. In order to appreciate this risk, it is important to revisit what has happened in the Chinese economy over the last 20 years.

The Chinese economy grew enormously from natural forces like urban migration and its position as a global manufacturing centre. Recently, GDP growth has had (like most economies) top down stimulus added from the state. This has mostly been through mandated infrastructure builds and bank lending to state-owned enterprises, and real estate projects. China continues to be in a delicate transition from a huge goods exporter to a new model that is struggling to sustain the same growth rate of the last decade. Instead of excess capacity being rationalised, it was expanded further with leverage. When there’s excess manufacturing capacity that is leveraged, it means that the owners of that capacity need to sell more goods to keep plant and labour capacity deployed. This means that goods are sold at even lower prices rather than not sold at all, which leads to profit margin pressure on companies. This is the primary reason why many local Chinese equities have had a difficulty in gaining upward price momentum over the last few years.

Growth and decline
During the 1980s, Japan was the envy of the rest of the world. Numerous academic studies were published about the efficiency of the Japanese manufacturing and export industry. The economy grew from $1trn in 1980 to $3trn by 1989. During the same time period, Japan’s stock market grew 11.72 percent per year. At the end of 1989, the Japanese stock market began its 20-year bear market and faced significant challenges of deflation, an aging population, excess capacity, an over leveraged real estate market and high loan losses in its banking system. A culture of pride, which had been reinforced by a decade of global admiration, made the recognition of these post bubble realities difficult to acknowledge and contributed to a protraction of needed policy reforms and economic restructuring.

China today is similar. Some of Japan’s challenges in the 1980s and 90s became China’s opportunities in the 20 years after 1989. Japan’s deflation era became China’s prominence era from 1989-08. One might argue that the onset of China as a competitor contributed to the deflationary forces that took hold in Japan. The important thing to take away is that Japan’s deceleration and stock market bubble bursting in 1989 did not spill over and have a long-term adverse effect on the US economy or stock market. One could argue that the deflationary pressures in Japan, and the rising alternative supplier of goods (from China) from 1989 onward, contributed to the growth in profits of US-based companies. Similarly, the deflationary pressures of excess capacity now in China could also have a positive impact on US profitability and GDP growth.

There are a number of conclusions we can draw from the above. The ‘fragile five’ are an insignificant part of global GDP and global stock market capitalisation. Instability in these countries is not likely to have a negative spillover effect on US markets. The potential deceleration of the Chinese economy is also not likely to have an adverse material effect on the US economy or stock market, but will continue to affect emerging market raw material suppliers. But in the shorter-term, global markets are affected by sentiment, and any contagion of a ‘China deceleration’ will certainly affect confidence, and hence valuations.

Countries like the UAE are running on a desynchronised expansion based on lower cost energy production and are now diversifying into tourism and other industries. Other frontier markets have also desynchronised and positive fundamentals can be attractive long-term allocations today, just as broader EM allocations were 20 years ago.

Valuation matters
There is no homogenous emerging market growth hypothesis built solely on demographics and GDP growth. Attractive pricing of that growth is imperative and no one should invest in GDP growth alone. Valuation matters. Country, regional and industry allocations are becoming more important determinants of long-term prudent portfolio construction. All investors should recognise the inherently higher volatility of emerging markets and be prepared to modulate portfolio volatility through international diversification. Finally, asset class diversification reduces portfolio volatility, giving an investor greater confidence and less emotional interference in asset allocation. Staying the course, but also recognising the big picture trends, is the key to long-term wealth building.