“Brazil faces worst recession since the 1930s”. “Chinese growth falls to a three-year low”.
The financial press is full of doom-laden headlines about emerging markets (EMs) – which is hardly surprising. After rallying strongly following the 2008 financial crisis, share indices across Asia, Eastern Europe and South America have spent the last few years largely in the doldrums – reflecting not just slower economic growth but also the actions of Western central banks.
While Chinese GDP continues to expand at 6.3pc, that’s well below the astonishing 9-10pc average annual growth the People’s Republic chalked-up during the 1990s and 2000s. Brazil, meanwhile, is mid-slump, contracting by 4.5pc during the third quarter, we learnt last week, reeling from lower commodity prices and the reversal of a consumer credit boom.
Energy-giant Russia is also suffering – not only from sub-$50 oil, down from $70 twelve months ago, but also economic sanctions, in place since mid-2014. Expected to shrink by 3.5pc this year, the Russian economy will register only its second annual contraction since the 1998 default.
Investor sentiment towards EMs turned decisively negative, though, before the macro-economic data went sour. Since 2013, long before commodity prices slumped, EM stocks have endured a torrid time, their demise coinciding with the winding-down of the $4,500bn expansion of the Federal Reserve’s balance sheet, otherwise known as quantitative easing.
As the West struggled out of the financial crisis in 2009, the large EMs – particularly China – replaced the US as the main engine of worldwide growth. Since global economic policy-making became dominated by Western money-printing, that’s changed. From 2011 onwards, as American QE became much more than an emergency post-crisis measure, some of the Fed’s monetary expansion found its way to the big EMs – pumping up not just Western share prices but also those in the East.
After 2013, though, as the US slowed QE and the dollar subsequently rose, such “hot money” portfolio investments began seeping away from EMs and returning to the West, bolstering shares in New York and London as more exotic markets fell. That flow became a rush this year, in anticipation of a US rate rise that will make dollar investments yet more attractive compared to shares valued in yuan, rubles, reals or rupees.
Even as the Fed has repeatedly shied away from actually implementing that rates rise, resulting investor concerns about the lack of action – “does the Fed know something we don’t?” – have hit the EMs hardest. Shares from China to India to Indonesia have been weighted-down, then, not just by the prospect of an increase in US interest rates but also from the rate rise being delayed.
That helps explain why the MSCI composite index of all EMs has fallen some 18pc over the last year while Western shares have been mostly flat or edged up. This impending US rate hike is part of the reason EMs will endure a net outflow of capital this year for the first time since 2008, the epicentre of the global financial crisis.
With many EM economies still overly dependent on natural resources, or on exports to sluggish Western nations, their prospects could well be seen as bleak. And with the Fed now expected to push through its first rate rise since 2006, the dollar – having already rallied some 20pc since 2012 on a trade-weighted basis – is likely to get even stronger. All that augurs badly for EM stocks.
There’s a growing school of thought, though, that EM shares could soon turn a corner. As growth picks up and weaker currencies help alleviate economic imbalances, “2016 could be the year EM assets put in a bottom and start to find their feet,” said Goldman Sachs in a new research paper. “There is the prospect of improved growth and better returns, even if it’s not a rerun of the roaring 2000s.”
There is certainly an argument to be made that EM equities have been oversold. Shares in the MSCI EM index currently trade at an average price-earnings ratios of 12, some 30pc below stocks in America’s S&P500. Many EM equities also offer attractive dividends, paying higher yields than their Western counterparts. While the IMF recently predicted the EM economies will grow 4pc in 2016, Goldman Sachs predicts such countries will expand by 4.9pc – which would represent the first acceleration in EM growth since 2010. “We would part ways with the extreme pessimism that we sometimes encounter about the long-term prospects for EM assets,” says the US investment bank.
Marketing spiel aside, it is certainly true that EM currencies have tumbled as the dollar has strengthened – which not only makes shares relatively cheap but has also helped various countries to tackle current accounts deficits that had previously made investors nervous. At the same time, with the Saudi government now under intense budgetary pressure, and oil prices hitting fresh lows ahead of this weekend’s Opec summit, there is growing speculation the Dessert Kingdom could soon soon revert to its natural supply-restricting tendencies. So it may be that the only way for crude prices, and the EMs whose financial assets are closely linked to commodities, is up.
As a life-long EM watcher, I care far less about timing the turning of the cycle than I do about the long-term trend. Yes, the dangers of investing in EM are real, significant and immediate. Corporate debt in such countries has increased sharply over recent years – and now stands at some 70pc of GDP. The International Monetary Fund is correct to point out that higher US rates could trigger a wave of corporate defaults across several EMs, not least as such debts – even if relatively low by Western standards – are often denominated in dollars.
Yet the fundamental direction of travel is clear. The EMs account not just for 75pc of humanity, but also 70pc of global currency reserves and 55pc of global GDP – up from just 30pc a decade ago. In 2010, adjusting for purchasing power, the combined economies of Brazil, Russia, India and China matched those of the US and UK. By 2020, even allowing for the current slowdown, these economies could easily match the combined size of the US and EU.
EM economies are very far from perfect, of course. They raise questions related to volatility, transparency and governance. But the West, if we’re honest, is also replete with systemic dangers – related to financial and public sector insolvency, monetary unwind and sovereign debt markets that are nothing of the sort. And, over the coming years and decades, the EMs – with demography and “catch-up” on their side – will unarguably account for the over-whelming share of global growth.
International commerce used to be totally dominated by flows of goods and services involving the big Western economies – with the “advanced nations” generally dictating the terms when trading with the rest of the world. Over recent years, though, there’s been a surge in trade between EMs themselves, bypassing the “leading countries” altogether.
As their share of the global economy has escalated, the EMs are increasingly trading with each other. Such “south-south” flows, just a few percentage points of world trade when the Berlin wall fell in 1989 now account for over a third of all cross-border commerce – and rising. This is the economic mega-trend of our time – not just the West-to-East shift but the fact that intra-EM trade will soon dominate the global economy. That’s why our long-term prosperity depends, crucially, on us trading with and investing in the EMs. This is the future that Britain must grasp.