Emerging markets were a major focus of Tim McCarthy’s book, The Safe Investor. One of the primary points of the book is that in our view, most U.S. investors invest too little outside their home country. Furthermore, in our view, too many investors have been conditioned to think that emerging markets rise and fall in lockstep with one another, and that the decision to invest is a binary one: they are either in or out of emerging markets. Going forward, we expect to experience more distinction between winners and losers in normal environments, and have adjusted our approach accordingly.
“No Country for Old Men” – The Role of Demographics
Demographics are a key element to the growth prospects for emerging markets, and often mentioned by proponents of emerging markets investing and skeptics for the prospects of developed markets. The importance of demographics was highlighted in the McCarthy book, and in a recent interview, Research Affiliates Rob Arnott said that “demographics are the markets’ 800-pound gorilla.” The demographic argument is a simple one: aging societies consume less, grow more slowly and have budgetary constraints tied to the aging population.
Japan is the poster child for the demographic burdens of an aging society, though the aging population is far from their only economic challenge. Emerging markets represent the other side of the coin, boasting younger societies with a much lower old-age dependency ratio.
In theory, emerging markets will offer faster growth, more consumption growth and favorable budgetary trends.
“Reversal of Fortune”
Many of today’s investors came of age in the 1990s, observing cycles in which emerging markets alternated between explosive growth and spectacular collapse. This boom/bust cycle was a function of immature economic development and governance, coupled with strains associated with the rapid growth enjoyed by many emerging economies. Fueling the turbulence was current account deficits, pegged exchange rate regimes, limited foreign currency reserves and a reliance on unstable sources of funding from foreign investors (see chart 3 below).
The IMF and developed markets central banks lectured emerging markets leaders from their soapbox, championing a variety of fundamental changes that in many cases became conditions tied to bailout programs. Emerging markets made substantial progress in recent years including lowered inflation (see chart 4), while developed markets in many respects deteriorated. The financial crisis was a catalyst for investors to realize how much has changed in emerging markets while seeing the demographic challenges awaiting much of the developed world. Many investor conversations in 2008 and 2009 highlighted the reversal of fortune, seeing a new reality in which the developed world faces high budget deficits, unstable banking systems, and unsustainable public finances. Emerging markets were arguably the biggest beneficiaries of quantitative easing, as generous liquidity conditions combined with the reversal of fortune between developed and emerging markets to fuel explosive rallies in emerging markets stocks and bonds.
Although the long-term prospects for emerging markets are compelling, the near-term outlook is far from rosy and the “bear case” for emerging markets has prevailed for much of the recent past. GDP growth and margins, which were so strong leading into the financial crisis, have declined. Ample liquidity from developed markets fueled the boom in emerging markets subsequent to the financial crisis, but with the gradual tapering of quantitative easing in the U.S., the liquidity boost is no longer as supportive of risk taking.
Last year’s “taper tantrum” shook investors out of complacency, and the rotation away from emerging markets was striking. Within emerging markets, liquidity conditions are far tighter than in developed markets as is earnings momentum.
Our caution about the near-term outlook informs our conclusions about the need to approach emerging markets in a more selective manner. For much of the history of emerging markets, broad-based rallies and crisis-driven crashes were mostly a top-down phenomenon. As emerging markets mature, we expect emerging countries to increasingly de-couple from one another, and within countries, we also expect some degree of de-coupling.
Emerging market countries have differing demographics, less synchronized economic cycles and varying levels of political and economic maturity. Although emerging markets exited the financial crisis in superior fiscal shape than developed markets, some of that “advantage” has been squandered through poor economic or political decisions.
Now, more than ever, the outlook for emerging markets is a nuanced one and selectivity is critical. Counting on a rising tide to lift all boats may be replaced by a more selective approach in which investors seek country, company or thematic opportunities. Although we’ve relied mostly on passive equity investments in recent years, an approach supported by our review of past performance and risk, we’ve been revisiting our approach to investing in emerging markets equities.
Investing in emerging markets requires more selectivity as well as awareness that market sentiment can change rapidly with each new element of incremental information. For much of the past decade, certain countries were beneficiaries of the “commodity supercycle,” the boom in commodities fueled by demand from China, a falling dollar and rapid economic growth.
The rising tide of growth tended to lift emerging markets as an asset class, with certain countries big winners along the way. Opportunities in coming years are likely to be much different, with themes including the rise of the emerging markets consumer, urbanization and structural reform. Commodity consumers rather than producers may be winners, a reversal of fortune from recent years that favored commodity rich companies. Asset-light companies, big winners in recent times in the developed world, may replace the asset rich firms that have been the big winners in emerging markets.
We think that tomorrow’s opportunities lie outside the countries and companies that dominate most indexes, and that there will be clear winners and losers.
It’s illustrative to see the stark contrast between the positioning that dominates the emerging market indexes and active positions taken by emerging markets portfolio managers. For example, we compared the most widely used emerging markets index, the MSCI Emerging Markets Index with a popular emerging markets fund, the Harding Loevner Emerging Markets Fund. The differences are interesting and thought-provoking.
Sixty-three percent of the MSCI EM index is concentrated in five countries—China, South Korea, Taiwan, Brazil and South Africa; less than half of the Harding Loevner fund is invested in those top five countries, and nearly a quarter is invested in smaller or frontier markets. he size of companies included is also interesting, with the weighted average market capitalization of the index approximately $34 billion, and the Harding Loevner fund nearly 25% less.
Active managers may also have pronounced sector differences from the MSCI index, which has more than 40% exposure to financial services and technology.Though the active approach may be a more volatile one, we expect interesting opportunities to come from smaller countries and companies.
Consequently, we currently are favoring active investments in the emerging markets asset class. Some countries are in much better fundamental shape than others, again supporting a more selective approach. In recent times, we’ve observed currency pressures, deteriorating economic indicators and political unrest among emerging markets countries. The developed world has largely been fixated by fears of deflation, while countries such as India and Brazil are struggling with inflationary pressures.
We think that some countries are better positioned than others, while at the company level there are companies that benefit from current trends while others are more vulnerable.