Euro Woes Won't Derail Emerging-Markets Growth

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Many investors are hoping that growth in emerging markets will help counteract some of the slow growth in Europe and in North America.

I am here today with David Lazenby. He is the Head of emerging markets and the senior portfolio manager with Batterymarch.

David, thanks for joining me today.

David Lazenby: Sure.

Glaser: So, let's first talk a little bit about how the European sovereign debt crisis is impacting emerging markets. We hear every day more dire news from the continent and more plans that don't seem to quite work in solving the problem.

Have you seen any impact so far on investment decisions that emerging-markets firms are making in response to the crisis in Europe?

Lazenby: Well there absolutely is impact. There is no question that we are not in an economy where the emerging markets' economic drivers can decouple from those drivers in the more developed part of the global economy, and certainly not from Europe.

The impact I think is less clear in the real functioning of the macroeconomy than it appears to be if you were to look at the returns to the financial markets. As I am sure you are well aware, the capital markets, particularly equities, but also more recently and particularly during this period of extreme volatility, currencies and fixed-income, which had been holding in relatively well, have underperformed this year, emerging markets relative to developed markets. So, the financial markets, the capital markets, are responding very negatively to the scenario that we are seeing, even though the epicenter of this crisis is certainly outside of emerging markets and in Europe as you highlighted.

But back to your specific question; absolutely, we are seeing increased uncertainty with regards to expectations of companies in the emerging markets world about their capital expenditures, their growth going forward. I would say that is fairly limited at this point. I mean, just a quarter ago you wouldn't have really seen much of that at all. You would have seen that they were continuing to go very strongly and not terribly concerned. And now they are just concerned enough that you are seeing some impact. You are seeing the questions. The growth is still there, the ongoing expenditures thus far are still there, but you are seeing questions and uncertainties surrounding this. I mean, you are seeing a bit, in certain places, of order books, not so much deteriorating, but not growing at the same kind of pace that they had been previously, for example.

Glaser: So, is it contagion that investors are worried about, that with Europe not demanding so many goods, there won't be as many exports coming out of Asia or out of other emerging markets, or do you think it's a lot of concern about another 2008 shock to the entire financial system?

Lazenby: I think it's a combination of both. I think what's getting people particularly edgy right now is more of the latter. I don't think there was ... with the exception of about a year ago, we did have that brief period when the relative outperformance of developed markets began based on an expectation that there was potentially some upside surprise coming in development markets' growth. EM, emerging markets, had been the growth driver. Developed markets looked like maybe they were going to recover a bit. Now, obviously, that's well behind us now, and those expectations have dramatically changed, but that did lead to some expectation of global growth being stronger, and not so much driven just by emerging.

<TRANSCRIPT>

But I think really, though, that the expectations in earnings in emerging-markets companies, the expectations in growth from emerging-markets macroeconomies in general, is increasingly, and has been for some time, increasingly dependent on intra-region, emerging-markets demand as opposed to really being dependent on exports in the developed world.

Just to maybe put some meat on that, if you look at the relative size of exports out of the emerging markets into EU, U.S., and Japan, into the developed world, and how much that has changed over the last decade, you would see that exports now, even out of markets like, say, Taiwan and Korea, which everybody ... recognizes as being driven by global drivers, in 2000 about 50% of their exports out of Taiwan and Korea, for example, went to the developed world, the EU, the U.S. and Japan, in the case of those two markets, spread across the three regions. Now, that's down to around a quarter of their total exports.

There certainly are individual economies with the ... Central European ones standing out as being very impacted by exports to the EU. For example, Czech Republic, Hungary, Poland, they export in the neighborhood of 80% of all their exports to the EU. So, there is very big impact in those, what I would characterize as being relatively small economies within the emerging-market universe.

Glaser: So, in your view what do you think growth is going to look like in the emerging markets over the next, say, five years?

Lazenby: We're still anticipating very solid GDP growth, and therefore EPS growth, coming out of that. We would still expect to see ... I guess the consensus right now for GDP growth in emerging markets over the next couple of years, is still in the neighborhood of between 5.5 and 6 times. I mean, China gets talked about a lot, and there are lots of questions about whether or not there will be a soft or a hard landing. I think one thing that we have to take into consideration when we have that debate or when you hear it being debated is that sometimes when people say they are expecting a Chinese hard landing, what they are actually meaning is 7% growth. So, the definition of a hard landing is very important for us to understand before we make a determination about whether or not that's going happen.

Our expectation for China specifically, for example, is that you will continue at levels above that 7% level, but recognizing that even the Chinese policymakers want growth to diminish somewhat from the level that it had been because that was too hot. So, the five-year plan that just came out from China to go specifically to your five-year period, they are expecting or, desiring frankly, a sort of a 7.5% to 8% growth in contrast to the higher levels that you have seen historically. So, that will diminish somewhat the averages across the emerging markets world relative to what we have seen over the last, say, five years, but still, we are talking 6% and beyond on average would be a not unreasonable expectation.

Glaser: So, overall, you don't expect contagion from Europe even if the crisis were to get worse, to have a major impact on emerging-market growth?

Lazenby: No, again, particularly given that ... internal domestic consumption is increasingly an important component of emerging-markets growth. Now, again, I am not by any means trying to say that if the world goes into a significant sort of financial crisis of the sort that we saw in '08 and '09, and therefore into a developed-market steep recession, that that won't have a growth impact on emerging markets. It absolutely will have. But they continue to grow, continue to have structural reasons for that growth to be there, with some pockets where you do need to worry about potential for capital misallocation creating places where maybe that growth has gotten ahead of itself. But in general, we think the fundamentals behind--the structural secular trends behind--that growth story that has been intact in emerging markets remain there.

Again, everybody spends a lot of time talking about China, but even over the last couple of years, China, which again is a market that's known as an exporter, everyone is afraid that they won't be able to consume or develop their domestic consumption enough to offset the export base. The reality is that in their GDP calculations over the last couple of years and what's expected this year is essentially no contribution from exports already at this point. It really is domestic demand that has been the driver of growth over the recent past, because of the relative weakness of the global economy.

Glaser: Taking a look at the firm level then, what companies do you think are better positioned to take advantage of these trends, and which ones do you think could be left behind?

Lazenby: Well, in general, obviously, from what I am saying, you have to tilt in the direction of companies that are more leveraged to that domestic demand story, that benefit not just from global growth drivers, but very specifically from drivers in the domestic economy.

... And when we say domestic consumption, I think it's important to highlight that we are not just talking about retailers and food companies or whatever for the basic consumption, but also that we are talking about companies leveraged to the ongoing infrastructure development, so capital goods. Even the sort of commodity story to one degree, and I don't want to overstate this, but to one degree is driven by ongoing development of domestic consumption in these markets.

So, tilting toward domestic stories and away from companies that are more leveraged to global and specifically developed-markets demand would be the way we would want to play that at a stock level.

Glaser: Well, David, thank you so much for sharing your thoughts with me.

Lazenby: All right.

Glaser: For Morningstar, I'm Jeremy Glaser.