False narratives: The myth of ‘superior’ emerging market growth
False narratives: The myth of ‘superior’ emerging market growth
In the second part of this series, Justin Leverenz explains why it is companies, not countries, that may deliver equity returns in emerging markets.
Many investors operate under the assumption that emerging markets (EM) equities can generate superior returns simply because EM countries generate higher rates of economic growth than the developed world does. In our view, not only is it incorrect to assume that all emerging markets are growing at a faster rate, but it is also wrong to use macro growth as the basis for investing in EM equities and pursuing sustainable returns. To generate long-term alpha in emerging markets equities, investors need to apply the same approach that should be applied to investing anywhere — invest for the long term in attractive companies with durable growth, sustainable advantages, and real options that will manifest over years. These opportunities exist not only in economies posting strong gross domestic product (GDP) growth, but also in low-growth economies where companies are able to tap into structural demand, and deliver innovative products and services or to monetize their unique assets.
The EM growth story has not lived up to the hype
The data show that, with a handful of rare exceptions, macro growth across the EM landscape has hardly been outstanding. Among the 20 largest EM economies, 15 have posted less than 5% compound GDP growth over the past 10 years — and this is nominal, not real growth!1 Beyond China, only India, Indonesia, the Philippines and Pakistan have posted high single-digit compound GDP growth over the past decade. It is worth noting that some of the largest economies in the EM world have hardly been able to sustain nominal growth, in US dollar terms, in excess of 1% compound over the past 10 years. These include Mexico, Brazil, Russia, Turkey and Poland. And frankly, the past five years have been even more brutal since the EM currency and commodity collapses and with the recessions across much of the EM world, particularly in Latin America (Brazil, Argentina, Mexico) and the EMEA (Europe, Middle East, Africa) markets (specifically Russia and Turkey).2
Figure 1: Nominal Gross Domestic Product (GDP) growth across emerging markets
Figure 1 also highlights another very important fact, which is that growth both across the EM landscape and the rest of the world has deteriorated significantly over the past decade. The superior EM growth story is really a residual of the first decade of the 21st century as evidenced by the fact that the 18-year compound annual growth rate (CAGR) for manyEM countries is considerably higher than the CAGR for the past 10 years.
In our view, the growth of 2000 to 2010 is anomalous, and unlikely to return anytime soon. It was a function of the convergence of several favorable trends: the rise of China, the boom in commodity demand and prices, and the “darling years” of globalization. In addition, the developing world benefited from the significant reforms forced upon EM governments to address the pressures associated with the Asia Financial Crisis (1997-1999) and its deleterious impact on commodity exporters. Thus, growth during the 2000-2010 period was amplified by a re-leveraging of most of the developing world.
Starting in the early 2000s, after decades of economic crises, the emerging world started to close the income gap with advanced economies and experienced growth consistently above that of the developed world. For many investors, the emerging world seemed to be on the promising path of convergence with developed economies, and that appeared to bode well for their ability to deliver more attractive returns relative to their developed peers. 3
EM growth challenge explained
We feel the real culprits for the EM stagnation problem are inequality and the lack of social mobility. We have written previously about the economic conditions in India, South Africa and Mexico. We view inequality is a major hindrance for growth in the developing world and, increasingly, in the developed world, as well. The dual-track economies prevalent in many large EM countries are characterized by a small and reasonably efficient formal sector dominated by a handful of companies that have access only to vast pools of informal (and inefficient) labor. The absence of social mobility impairs these countries’ capacity to bring much of the population into higher productive sectors and ultimately reduces their national savings and capital formation, which are critical drivers of development. In equality, perhaps the most significant economic challenge of our age, is pronounced in much of the developing world. These circumstances are particularly extreme in South Africa, Colombia, Chile, Brazil and Mexico, as revealed by the Gini Index, which is a measure of a country’s income dispersion. (Figure 2). However, it is worth noting that many of the larger economies in the EM world have reasonably small upper/middle income populations within large overall populations that rival the population size of some continents. That means the underlying inequality is significantly higher than what the Gini-coefficient measures. Countries that fit this profile include India and Indonesia.
Figure 2: Gini Index
Insufficient state resources are another key culprit contributing to the development challenge in many emerging economies. Simply put, many EM governments have insufficient fiscal resources to improve social mobility through the necessary investments in physical and social infrastructure. Brazil is perhaps the most notable exception to this. While Brazil is a big state in terms of resources, it unfortunately suffers from dysfunctional democratic institutions. The consequences of that have been limited discretionary spending, high debt, and a massively inefficient administration.
Figure 3: Ration of fiscal expenditure to GDP (%), 2018
An aside we never get tired of pointing out…
We want to make an important aside in this discussion, which is that four of the largest EM economies are inappropriately labeled EM economies. These four are evenly divided between highly industrialized, productive but small, open economies (South Korea, Taiwan), and rich Gulf states with small populations and abundant hydrocarbon resources (Saudi Arabia, United Arab Emirates).
Figure 4: GDP per capita—Purchasing Price Parity (PPP)
The exception that is China
China, of course, is the true growth engine of EM — one that has been running now for nearly four decades! Despite significant headwinds from a deterioration in external demand, China has been able to deliver 11% CAGR nominal GDP over the past 10 years and 14% CAGR from 2000-2018. China has accounted for 45% of the increase in EM GDP (among the 20 largest economies) since the beginning of the century and has added $12 trillion of GDP during the past 18 years. This contrasts with $2.2 trillion of GDP in India, $1.4 trillion in Russia and $1.2 trillion in Brazil, three of the other large EM economies. China’s contribution to global growth is also larger than the $10 trillion of GDP growth that the United States has posted this century, despite the fact that the US is a significantly larger economy. All of this has resulted in China becoming an economy nearly as large as the next 19 largest EM economies combined. China accounted for 45% of total GDP generated in these countries in 2018.
Where to go from here
To sum up, the case for investing in EM economies, more broadly, is NOT about superior economic prospects, or these economies’ convergence with the developed markets of Europe, Northeast Asia, and the United States. In a world of deglobalization, improved growth prospects in wide swaths of the developing world will depend on structural reforms. Fiscal reform, administrative efforts to improve social mobility and financial inclusion, and state capacity to invest in physical and social infrastructure are really the political imperatives to structurally improve growth. As we noted in part I of this series (False Narratives: Rise of the Emerging Market Middle Class), we see glimmers of optimism throughout the developing world with the political rise of “the progressives” across the EM landscape, including Indonesia, Mexico, India and pockets of sub-Saharan Africa. Time will tell how this story unfolds.
Nevertheless, the real case for investing in EM equities over the long term remains unfazed: one can capture the opportunity of EM by looking to uncover extraordinary businesses that have the capacity to generate above average earnings growth, even in pedestrian macro environments. This has been the hallmark of our approach to investing in the developing world for decades.
In slower growth economies — in both developed and emerging markets — there are two broad categories of companies that meet these criteria: globally competitive companies that are not entirely dependent on their domestic markets and domestic disrupters that gather market share in their own markets over time because of their significant efficiency advantages.
This article has been edited from the original. Justin Leverenz is a Team Leader and Senior Portfolio Manager for the OFI Emerging Markets Equity team at Invesco.
^1 Source: Unlike real gross domestic product, nominal gross domestic product reflects price changes from inflation.
^2 Source: EM Advisors as of Dec. 31, 2018
^3 Source: The World Bank as of Dec 31,2017, the most recent data available
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