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.
“Setting Free the Bears”