For most of the past decade, investors have deemed emerging markets (EM) “the best thing since sliced bread”, says Jan Dehn of Ashmore Investment Management. But now the fashion has faded. EM stocks have underperformed global ones in the past 18 months or so. The problem? It’s become increasingly clear that the “main driving factors behind EMs’ great decade” are “unrepeatable” and have “played themselves out”, says John Authers in the Financial Times.
The Brics are crumbling…
EMs’ share of world output has jumped from 38% to 50% in the past decade, thanks largely to Brazil, Russia, India and China (dubbed the ‘Brics’). China fuelled growth in Russia and Brazil by stoking the commodities boom. But now China’s “turbocharged investment and export model has run out of puff”, says The Economist. Its “precarious shift from investment-led growth to a more balanced, consumption-based model” – which could well entail a hard landing as its credit bubble bursts – along with its ageing workforce, implies more pedestrian growth in future.
Without the prop of rising commodity prices, underlying structural problems in the Brics have been exposed. Russia and Brazil are growing at just 2.5% a year. Brazil’s households have borrowed heavily to finance consumption in recent years, while stubborn inflation, pervasive red tape, and a lack of investment has hampered growth. In India, reforms are progressing slowly, but inflation is stubborn and government overspending has crowded out investment. Growth has fallen from near-double digits to an annual pace of 5%.
EMs as a whole are expected to grow by 5% this year. That’s the slowest rate in a decade, barring the 2009 slump when the rich world collapsed. Non-Bric EMs continue to grow strongly, but they are much smaller than the Brics and are starting from a higher base, so there is less scope for rapid growth spurts to catch up with the rich world. So this looks like the end of an era for EMs.
…and global liquidity is set to fall
The other key issue is the prospect of an end to easy money in America. As bonds worldwide are priced off US ones, an end to money printing, and higher future American interest rates, implies higher rates worldwide. With the implied return on developed-world assets rising, traditionally riskier plays, such as EMs, lose their appeal. So money flows out of them, hampering growth. Earlier this year, when it first became apparent that an eventual end to money printing from the Fed was in prospect, EM bonds suffered their worst sustained sell-off since 2009.
Is it time to buy?
So the tide has turned. But that’s not to say investors should ignore EMs. The structural changes in these countries that have impressed investors in recent years are still broadly on track. Developing economies in general continue to deregulate and most are “models of fiscal rectitude”, as Blackrock’s Russ Koesterich points out in the FT. In many cases sovereign debt-to-GDP ratios are below 50%.
What’s more, adds Alex Frangos in The Wall Street Journal, developing economies are more resilient to potential crises caused by money fleeing from risk these days. There’s less debt denominated in foreign currencies (this can be a problem because the cost of servicing such debt rises when investors panic and rush back to developed assets, and emerging currencies weaken). Governments have amassed “mountains of foreign exchange reserves”.
Finally, the darker outlook looks to be in the price. EMs as a whole are on a cyclically-adjusted price-to-earnings (p/e) ratio of 13, down from 30 in 2007. Russia, China and Brazil are on single-digit p/es. It’s time to start eyeing them up again.