Booming emerging markets are heading for straitened times – but there are still profits to be made, says Jonathan Compton.
It is impossible to be too cynical about how to create robust economic growth for any country. The formula to induce a prolonged boom is both simple and immutable.
First and foremost, you need a young, rapidly urbanising population. Keep spending on welfare, defence, pensions and health to a minimum, suppress wages, and allow employers to treat their staff like cattle. A minimal democracy or benign dictatorship is the preferred form of government, although a simple legal system ensuring property rights and contracts is a must.
The national budget should be balanced, or even run with a small surplus. Investment should focus on building up infrastructure such as roads, harbours and airports. Ideally, there will also be a shortage of natural resources, which forces the economy to mass-produce cheap goods for export.
Any country with these ingredients has enjoyed a boom over the last 50 years. The most obvious examples have been in Asia: Japan, Korea, Taiwan, Singapore and Hong Kong. In fact, far more surprising is the sheer number of nations that had most of these ingredients, but until recently showed a gritty determination to ignore their opportunities and remain poor. The main examples here include China, India, Brazil and South Africa – four of the five Brics nations (Russia is the other) more recently lauded as economic miracles.
Until the early 1990s, for example, China adhered rigidly to its Iron Rice Bowl principle (equal misery for all). India too emphasised self-sufficiency and hindered the import of better foreign technology, ideas or capital. Brazil and South Africa, each with abundant natural resources, used profits from these to placate the urban masses with subsidies. All four created Byzantine controls on everything from imports to tourism, ensuring domestic inertia.
These problems have only been addressed slowly since late last century. Today, developing countries account for just over half of global domestic product, compared with 31% in 1980. But given that they form 75% of the world’s land mass, hold 85% of its population and (through their central banks) own 75% of the world’s foreign-exchange reserves, it is staggering that they haven’t done better.
When they were colonial dependencies or pawns during the Cold War, opportunities for growth were suppressed, but since the fall of the Berlin Wall in 1989, these obstacles no longer apply.
Yet now the miraculous growth in most developing countries has hit a brick wall. The bad news is that it is unlikely to return to previous levels – any country that failed to seize its chances during a uniquely benign period faces, at best, a difficult future. Those that did will have to be even more nimble to maintain their edge – storms lie ahead. Profits are about to be squeezed, surpluses disappear and government spending soar. All are bad for growth.
Of course, there are exceptions. But most emerging nations have key trends in common. The first is demographics. Birth rates have fallen and life expectancy increased. The result is a rapid deterioration in the elderly “dependency ratio” – the number of over-65s per 100 people of working age. The lower the ratio, the greater the burden on government coffers for pensions and health care. For example, in Japan there are just 2.4 people of working age for everyone over 65, and the ratio is getting worse.
By contrast, China is on 7.1, India 11.1, and Brazil 14.2. Yet over the next five years the number of retirees across Asia (excluding Japan) is set to grow on average by 21%, while the 15-24 age group falls by 11%. Most emerging-market governments have not budgeted for the extra costs this will entail, which will also need to be funded by a smaller workforce. Projections for 40 years’ time are horrible, suggesting one dependant for every 1.5 working people (worse than America, and almost as bad as Europe).
Then there are defence budgets, which will have to rise sharply. Many developing countries have long enjoyed protection under Uncle Sam’s military umbrella, while those once within the sphere of the USSR could also afford to be miserly when it came to spending on armaments. But now America’s appetite for major foreign adventures is over, along with its ability to provide huge military power in every continent.
Meanwhile, various developing nations have become more bellicose as they have achieved new levels of wealth. For example, China’s Asian neighbours are being forced to reappraise their strategic needs. And in the Middle East and Africa, both America and Europe have washed their hands of meaningful new involvement. So local governments will have to rearm.
Defence spending varies considerably from country to country. But most have underinvested. The Philippines is at the centre of China’s crosshairs, yet only spends 1.3% of GDP on defence. China also claims Indonesian territorial waters – yet Indonesia spends less than 1% of GDP on its armed forces. Both will be forced to triple their spending to replace the American umbrella – all before the extra cost of updating often archaic equipment. The only continent where defence costs are justifiably low is Latin America, given a lack of major disputes.
Pensions are another problem. I was amazed in 1994 when I visited an Indonesian cigarette maker to discover it offered a generous final-salary scheme. Then the catch became apparent – from the age of 14, staff were allowed to smoke for free all day. The average worker died aged 54. Many emerging-market miracles have been built through similar skimping on pensions and health, for which provision has been low to nonexistent.
Among wealthy nations, public spending on old age and related benefits averages out at 8.2% of GDP. Among the leading developing countries it is below 4%. That’s a yawning difference that cannot be accounted for by their usually younger populations. Worse still is health care spending. Of the 192 countries for which data is available, a median 6.3% of GDP is spent on health (both public and private spending). Among the developed countries, it’s 11.2%. Yet given higher birth rates and the prevalence of major diseases virtually unknown to advanced nations, it should really be the emerging markets that spend most on this.
These are just some examples of the chronic underinvestment that represents a real and immediate problem to developing countries, if only because of rising expectations. From Brazil to China, elected and appointed politicians have to be increasingly populist if they wish to stay in power. Forty years ago, when the majority of the developing world’s population was rural, information on how badly off they were or on how they were being treated at work was almost nonexistent, as was any defence against oppression.
The revolution in communications over the last 20 years, through huge changes in social and broadcast media, has changed expectations. By tapping a few buttons on a mobile phone, anyone can now access information on their relative poverty and the derisory level of services provided by government and employers alike.
They can see that of the world’s top 100 hospitals, only three are in developing countries. And that in 69 countries – perhaps including their own – 1.6 billion people lack access to safe drinking water; or that on the UN Environmental Protection index (which measures several forms of pollution), their grandchildren’s life expectancy is less than their own. Then there are the credit and aid markets. Gone are the days when international lenders would happily bankroll notorious dictators and gangsters, from the (AAA-rated) Shah of Iran to the Philippines’ kleptomaniac President Marcos.
Aid agencies too have become wary of supporting those countries that fail to improve social and welfare spending. As a result, the pressure on many emerging markets’ finances is about to become severe. This must lead to higher government taxation and spending, which will act as a brake on economic growth. In the private sector, as workers have become better organised and more mobile, so demands for higher wages and better conditions have grown, which will affect profitability.
The change from rapacious capitalism and exploitation to a more egalitarian ‘social democracy’ model will prove impossible for many emerging economies. They will remain wedded to a cheap labour/high export model and fight all reforms that impact on the status quo. But the forgiving conditions that fuelled the boom of recent decades have passed. That also means that investors have to be more picky about exactly what they invest in and where. I look at some of the more promising areas in the box on the left.
Five promising stocks to buy now
The good news for investors is that slower growth should not be a concern – as has been pointed out in these pages many times before, there is no meaningful correlation between economic growth and stockmarket returns. However, despite their low cost, index trackers and exchange-traded funds are largely poor investments in emerging markets because most indices groan with the largest ex-growth stocks – heavy industries, natural resources and government-controlled firms.
Instead, as a play on smaller workforces (as wage costs rise and populations get older), the Japanese robotics companies Yaskawa Electric (JP: 6506) and Fanuc (JP: 6954) are global leaders. Meanwhile, ageing and wealthier consumers also tend to trade up and buy specialist anti-wrinkle creams and cosmetics. A beneficiary of this is Hong Kong-listed L’Occitane (HK: 973), a strong brand. Healthier eating and special dietary foods are another function of both wealth and age. Taiwan’s Standard Foods (Taiwan: 1227) is a local market leader and one of the safer plays.
Finally, as much as the future can be foretold, growth in tourism and regional travel, led by wealthier workers and silver surfers alike, will remain a powerful trend. My best pick for this remains the number two short-haul aeroplane manufacturer, Brazil’s Embraer (NYSE: ERJ), whose share price has barely changed from when I last recommended it in May 2014.
• Jonathan Compton spent 30 years in senior positions in fund management and stockbroking.