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The Furious Comeback of Emerging Markets

Our panel sorts through the current buzz of ideas surrounding emerging markets.

Arijit Dutta and William Samuel Rocco, 10/20/2009

Blame it on emerging markets. That seemed to be a fair line to take not too long ago, when any systemic financial crisis could usually be traced back to a series of debacles in developing markets. The current global financial crisis, however, originated right here in the United States. And yet, emerging markets were among the most brutally punished as investors indiscriminately fled all risky assets.

Many are perhaps realizing last year's verdict was too harsh. Morningstar's diversified emerging markets, Latin America, and Pacific/Asia ex-Japan categories are up between 46% and 63%, which are by far the best results among all domestic and foreign categories.

We invited fund managers Rusty Johnson, Arjun Divecha, and Andrew Foster to participate in a conversation via conference call on Aug. 3, so they could share their insights into emerging markets' investing merits and drawbacks. These veteran managers have tracked many powerful changes in this asset class over the years, and shareholders at their funds have benefitted from the investing themes they have sniffed out.

Johnson is the lead manager of Harding Loevner Emerging Markets HLEMX as well as a comanager of Harding Loevner Frontier Emerging Markets HLFMX. His high-quality growth strategy has delivered strong long-term returns with relatively moderate volatility during his 11-year tenure at Harding Loevner Emerging Markets. Divecha has led the charge at GMO Emerging Markets III GMOEX for more than 15 years. His mostly quantitative--but augmented by fundamental analysis--approach has produced strong results during his tenure. Divecha was recently promoted to be the chairman of the firm, after Jeremy Grantham, GMO's famously contrarian market prognosticator, stepped down from that role. Foster is the skipper at Matthews Asian Growth and Income MACSX. He is among the thought leaders at Matthews' formidable group of Asia experts. The firmwide focus on domestic growth and lesser-known stocks gives investors at Matthews funds a distinct, off-the-beaten-track look at Asian markets.

The conversation has been edited for clarity and length.

Arijit Dutta: About a year ago, there was much talk about decoupling and that emerging markets would escape the crisis. The crisis didn't originate in emerging markets, people argued, and emerging markets now had their own growth engines. In late 2008, both those theories were shot to hell. Yet now it seems like the decoupling argument is arising again. What are your thoughts on this topic?

Arjun Divecha: First of all, the idea of using a single concept called decoupling to encapsulate a whole range of complex issues is very narrow-minded. There is not a single dimension to emerging markets.

Having said that, the way I think of most emerging economies is that they are like a boat with two engines. One engine is export-driven; the other engine is domestic consumption. Clearly, a decoupling to the West and developed markets cannot happen on the export side. If developed markets do not recover, demand does not recover, and the export engine is going to stay broken for a while. On the other hand, we have the domestic consumption. This is where you've seen the new decoupling that people recently have been talking about. Domestic demand and consumption have been stimulated through massive fiscal and monetary spending. It is working as you would expect it to, because for most of these countries, this is not a structural crisis; it is a cyclical crisis. The United States and developed markets, for the most part, have had a structural crisis; they will have to change their financial systems coming out of this. That's not true for emerging markets.

Rusty Johnson: I agree. To say that emerging markets can be completely delinked from developed markets, as big as they are, is just not logical. True, the big economies are slowing and the growth rate of the emerging-market economies is likely to be lower, but they're probably not going to be directly linked. Another aspect that has created this illusion of a complete decoupling is the credit issue. In December, January, February, credit froze up around the world. Nobody knew what was going to happen. Corporates understandably were afraid even in developing economies. This was a period when the developing economies did look like they were plunging with the world. But it was short-lived.

Andrew Foster: Decoupling is not necessarily a desirable state. The biggest emerging markets, like China and India, have grown because they have coupled with the rest of the world. It's the export engine that Arjun was talking about. But it's also very much the fact that these markets open themselves up for business domestically to external competition. It's been that very favorable coupling that's taken place that has powered the growth over the past two decades. True decoupling--what we see in North Korea and Pakistan, where domestic events and politics are so strained that the economies are severed from the world--is undesirable.

Also, building on what Rusty said, the credit hiccup hit emerging markets because their capital markets are just not as deep yet as the developed markets. The bond markets in China and India are really small, especially the corporate bond markets. As a consequence, the pools of capital that could help see these countries through a retrenchment in credit elsewhere in the world essentially dried up. That's why we saw the destruction we did. Capital markets now are picking up steam, which will help emerging markets ride out some of the global shocks in the future.

Dutta: Some of the data coming out of China have been astonishing. We're hearing that a lot of these growth statistics are being driven by investment and government spending and that it's going to create a lot of overcapacity. Do you agree?PAGEBREAK

Foster: The big shocker of the year has been that China's growth has held up remarkably well despite the fact that its export engine is out of commission. Some economists are predicting that China might even have monthly trade deficits. I'm not sure if it will go quite that far, but exports are contributing almost nothing to the economic growth there. But China's last quarterly GDP figure was a 7.9% expansion year on year. That was a big shock to everyone. We're not surprised to see that the domestic side of the economy was so strong. People under-appreciate the fact that both domestic consumption and domestic investment account for more than two thirds of the growth in the Chinese economy. My own research there has shown that there's a great deal of consumption still taking place.

Still, the pace of the investment that's being spurred by government stimulus is a big concern. China's been quite successful at stimulating its economy in a way that most other economies around the world would be quite jealous of. That said, China does need to do more to boost domestic consumption. It has been growing at a very rapid rate, just not as fast as the economy as a whole, and as a consequence, the percentage of the economy that is driven by consumption is lower than everyone would like to see.

Dutta: Arjun, are you worried about the numbers coming out of China?

Divecha: Yes. Going into the crisis we were worried about overinvestment. Our belief is that overinvestment inevitably leads to low return. It may lead to high top-line GDP growth, but that doesn't mean that it leads to high returns for investors. Clearly, the stimulus has had its desired effect in terms of stimulating more consumer behavior and all kinds of good things short term. But we think that the stimulus has really had a profound impact on overinvestment. Let me put it this way: If the banks did not have a bad loan problem going into the crisis, they will almost certainly have one a year or two from now, because a lot of the lending that is being done is not good-quality lending.

Johnson: I share these concerns. China's made it clear that they'd like to see a better- balanced economy. I don't think they like to be so dependent on export because it brings in a whole range of external issues, politics, and what have you. They understand clearly that they want to get a deeper base of a consuming society. They're working their way there; you don't build it overnight. If you build a new cement plant or a road, it has a more immediate impact on your GDP, but I think they're going to try to move toward the softer-side services and a more- domestic economy.

Foster: I went to China in May to tour some of the banks, because everyone around the world was a bit breathless over this pronounced extension of credit in China. I think the system itself is quite liquid and solvent and can digest this in the short run. There's really no strain being put on China's banks. They're still running with loan and deposit ratios under 70%, because there's been an enormous amount of deposit creation alongside this credit extension.

The bigger issue that Rusty was hinting at is how productive is the investment going to be, and it does seem to be channeled to state entities for infrastructure projects. We, too, have some concerns over how productive this will be and whether or not, when the loans come through in five and 10 years time, the projects will have earned a reasonable rate of return on capital. It looks like the state in most instances is a guarantor behind these projects, because they are of an infrastructure bent for the most part. In that respect, China's fiscal position is incredibly healthy compared with most other governments around the world.

Dutta: Has the crisis caused any major structural changes in emerging markets?

Johnson: Well, one area is banking. There's been a big change in global banking, and emerging-market banks are the big beneficiaries. By and large, the emerging-markets banks are demonstrably healthy, as Andrew mentioned. They're almost exactly opposite of what Western banks are. They had good lending opportunities, they had ample spreads, they were funded by domestic deposits, and they are without a large degree of external lending, without a lot of leverage and stretching, if you will. They are in a much better position to support their economy and lend at high margins. It's very likely that the amount of global capital--particularly the U.S. dollar, which was slopping around at very low interest rates as money chasing lending--has contracted substantially. Global credit will be less available and priced more according to risk. Emerging-market banks that are in strong financial positions are going to be in a much better position to earn decent returns going ahead.PAGEBREAK

Foster: We are paying a lot more attention to the development of the fixed-income markets, especially for corporate issuance in Asia Pacific. The missing link in Asia Pacific has been deep and robust bond markets to efficiently and transparently finance long-term infrastructure projects. The bond market is one of the important developments that people need to pay attention to over the next five and 10 years.

Alongside that, people should no longer take for granted the currency linkages. Some of the Asian currencies, in particular, have been at least implicitly linked to the dollar. That linkage is no longer going to be a key one going forward. Many of the central banks in the region are acting to create a credit stimulus and manage their own domestic interest- rate policies. Over the longer term, that means some of the linkages around currencies will probably break down.

Divecha: We're watching how the role of demographics will play out long term. For example, the link between demographics and savings rates. Ten years ago, the average saving rates in India was about 8% of GDP. Today, it's over 30%. It's the same across all the emerging markets. We're seeing a much higher proportion of the population moving into their working years, which is very positive for emerging markets and will continue to remain positive for the next 20 to 30 years. In the West, as the baby boomers retire, the demographics are turning sharply worse. The ramifications of this for most emerging markets are huge. Whereas 10 years ago most of them would have had to access foreign capital markets in order to develop, now with the savings rate going up because of this demographic dividend, they have the ability to fund growth domestically. That's why Andrew's point about the bond markets becomes quite important.

Dutta: Arjun, what about the point Andrew made about currency links breaking down? You do a lot of macroeconomic modeling in deciding your country rates. What kind of evidence have you seen on that front?

Divecha: What Andrew said is exactly right. There has been a gradual process of emerging markets effectively running independent currency and monetary policies, rather than linking themselves to the dollar or to the euro. As a result, we think that the currency of countries that have fast growth will appreciate relative to countries that have slow growth. It's sort of a Samuelson effect. In the long run, emerging currencies will in fact appreciate in real terms relative to the developed currencies as long as the growth rates are higher, and I certainly think you can make the case that growth rates will be higher. That case is strengthened by the fact that emerging markets are now running more independent currency and monetary policies.

Foster: The one caveat I put around this discussion is that the dollar casts a huge shadow over the markets, especially in Asia Pacific. Until there's a surrogate for the dollar to help provide financing for long-term credit in the region, I would expect some shorter-term volatility in the currencies of the region that may not be representative of the unilateral strength in the Asian currencies. There has to be something that helps replace the liquidity that's currently based in dollar capital markets.

Dutta: What are some of the biggest risks in emerging markets that you see looming on the horizon?

Johnson: The amount of money China has invested. I go there and find oceans and oceans of empty property and office buildings. They have invested a tremendous amount in fixed assets. I think it could cause a bit of a hiccup. China has the money. Morgan Stanley said in its weekly report that China basically uses its balance-sheet strength to flow its income statement. The amount China has shocked into the system is understandable in a world in crisis, but I'm concerned about how this is going to turn out. If China starts to overheat or has other problems, what will be the ramifications on the emerging markets? My second concern is inflation ticking back up, but I don't see that happening for quite awhile.

Divecha: I agree. I also worry about another downturn, which is not out of the question. But I worry mainly about protectionism coming out of the developed markets. It could be catastrophic both for developed markets and emerging markets, but the impact on emerging markets would be worse, certainly in the short term.PAGEBREAK

Foster: Another concern--related to your point, Arjun--is that some of emerging-markets countries that have recently opened up their economies will backslide in their efforts. I think there's a danger that all of the questions overhanging free-market capitalism will cause officials in these countries to turn away from open-market models.

I'm also still concerned about good, old-fashioned political risk. I think that Pakistan is one of the scarier places on Earth in terms of the stability of the government and the fact that it has a nuclear arsenal. I worry that the relations with India could deteriorate and cause greater strife in the region. Likewise, there appears to be a transition in power under way in North Korea, and I worry about that as well. Political risk is something that people don't talk about much anymore because it's hard to measure. But it's a serious source of risk.

Johnson: A large part of the resource bases and the wealth in emerging markets are still controlled by governments. Almost every emerging oil company you can think of, excluding Lukoil LUKOY, is state-controlled. Wealth-creation in emerging markets is moving toward the economies that are less democratic, making it inevitable that there's going to be more political interference. Sometimes, the political intervention, as in China's case, has been massively supportive. They didn't save the world, but they certainly saved China and a good bit of the emerging market.

The other thing that has become more apparent is that political risk or political intervention is sometimes asymmetric. When inflation is falling and economies are good and there's no social strain, governments tend to stay out of the equation. But when inflation is on the rise and there were food shortages, the policy response of governments became much more Draconian. To some degree, it is warranted, but my point is that the political interference ebbs and flows.

Dutta: What about some of the positives? What are some of the opportunities that you're seeing?

Divecha: We are primarily value managers, so we look for stuff that's cheap. The countries that are cheap to us right now are Korea, Turkey, Thailand, and Russia. Korea has links to the rest of the world, but the other ones clearly have turbulent economies. But we think that times of crisis present the best opportunities to pick up stuff that's cheap. As I like to say, you make more money when things go from truly awful to merely bad than when they go from good to great.

Foster: We're following the same premise that we followed before the downturn. We look for areas, markets, and economies that are not well represented in the benchmark indexes or in the capital markets, but that are substantial in the underlying economy and are continuing to grow. To illustrate, about a decade ago, China in Morgan Stanley Capital International's Far East Asia benchmark had about a 1% weighting. Taiwan has a little over a 20% weighting. The reason for it was that even though China was large and growing rapidly, it didn't have a whole lot of capitalization associated with it and it was very difficult to access. Taiwan was much easier to do. This might have seemed logical at the time, but it was entirely the wrong premise on which to invest for the next decade.

Today, what is underrepresented are some of the key growth drivers of the economy. Health care, for example, gets about a half percent weighting in emerging Asia benchmarks. It's a relatively small industry and it's difficult to access, but it's very difficult for me to believe that given the amount of investment that's going into health care and its burgeoning demand that it isn't going to be a very substantial market in a decade's time. These kinds of portions of the market that are underrepresented are very attractive to us.

William Rocco: Could you talk about the evolution of your universe over time? For example, for years, we've talked about Korea graduating to developed status. And on the other end of the spectrum, how do you think about frontier markets? Rusty, maybe you could start because your colleague Don Olson runs an institutional frontier-emerging-markets fund.PAGEBREAK

Johnson: As far as I'm concerned, Korea's ready to go to developed-market status. They have most of the big issues that are necessary to migrate: Per-capita income is high, banking penetration is high, education levels are world record, Internet and cellular phone penetration is high. Korea shows a lot of characteristics of a mature economy. The banks struggle to earn a return on asset of 1%. So I think it's prepared to go. In fact, it's part of our struggle with Korea. We don't find deep underpenetration of services and products that you can find elsewhere in emerging markets. It would be a good thing for Korea to move on and allow more capital to come into the developing economies.

At the other end, there's no bright line between frontier and emerging. The governments of most frontier countries have started to read the rule book on how to grow their economies. Our frontier group, for example, sees parallels between Nigeria and Brazil. A lot of state-owned enterprises in Nigeria are struggling with privatization and corruption. There's a high degree of fear, but they understand the path where they need to go. Nigeria is a big country with a lot of resources. It has the potential to evolve into a serious developing economy.

Foster: Working here at Matthews, we are regionally focused. For us, the distinction between an emerging market and a developed market is increasingly blurred. We see it as more of a binary construct of how money is benchmarked and indexed. It really doesn't fit with the fact that these countries are evolving across a whole series of different spectrums--political sophistication, openness of capital markets, currencies, development of major industries, etc. Take China, for example. It's both a developed market and an emerging market. There are pockets of that country that are every bit as developed as the major developed countries around the world, and there are pockets that are impoverished, where development is far behind.

Divecha: My distinction between emerging and developed markets--which I've tried to convince the people from the index committees to think about--is not so much market development, because there are a number of emerging markets that are certainly more sophisticated and more developed than, say, Norway and Finland. To me, the distinction between an emerging and developed market is that a developed market has a finite probability of catastrophic loss. Korea, because of the North Korea dimension, is in my book an emerging market.

We think a lot of the frontier countries are getting more interesting. We include 18 frontier countries in the set of countries from which we can pick. Realistically, given the size of the assets that we manage, the amount of money that we can put into some of these places is very, very small, so we don't see frontier markets as being a substantial part of our assets. But as they develop, become more liquid, and become more accessible, we could see putting more assets into frontier markets.

Foster: But hasn't the premise that developed markets have only a finite chance of loss been overturned in the past year? We used to say that a developed market is one where there was transparency of regulation, a fairly free and vibrant private sector, and without a huge amount of government intervention, regulation, or subsidy. We're starting to see those lines being blurred, and it's hard for us to say with clarity what delineates the two.

Divecha: I don't have any dispute with what you're saying. My point is simply that the probability of some government action or something that could have a major impact on foreign shareholder's holdings should be taken into account.

Arijit Dutta is an associate director of mutual fund analysis with Morningstar. William Samuel Rocco is a senior mutual fund analyst. Arjun Divecha

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