Why quality of growth matters
by Philip Saunders
The evolution of emerging market economies should be a key point of focus for global asset allocators today. Charting their development is not a simple task, given the diversity of economies, companies and asset classes that all fall within the broader emerging market umbrella.
Yet the recent volatility and underperformance of many emerging market assets have made investors question not just their long-term investments, but also the way in which they think about the evolution of the opportunity presented to them.
The process of development in emerging economies is likely to be enduring, driven by the expectation of rising living standards. The path of development will be neither smooth nor universal but, in most countries, any faltering or reversal of momentum should result in renewed pressure to accelerate market-based reforms. This will come not just from the international community but, more importantly, from populations increasingly able to compare their fortunes with progress in similar countries.
With risk and volatility, perceived or real, being the price of the opportunity for excess returns, investors will need discipline. This means country by country, sector by sector and company by company analysis.
Emerging market economies are highly differentiated, with diverse drivers of development, growth and returns. In each, there are some key development components that will drive investability and returns.
Collapse of communism
The dismantling of the Iron Curtain and the collapse of communism in eastern Europe towards the end of the 20th century was not just a major political event, but an economic one too. Economic growth, which averaged 2.5% in emerging economies in the 1970s and 1980s, compared to 3.3% for developed economies, has risen to an average of 5.9% since 2000, compared with 1.9% for developed economies. Emerging economies accounted for just 16.8% of the global economy in 1990, but now account for over 50%.
Investors have benefited. The compound total return for the MSCI Emerging Markets Index from the start of 1990 to the end of May 2014 has been an annualised 7.9%, comfortably ahead of the 3.2% annualised compound return of the MSCI World Index. Similarly, from 1994 (when the data series started) to the end of May 2014, the J.P. Morgan Emerging Markets Bond Index returned an annualised 9.8%, well ahead of the Citigroup World Government Bond Index, which returned 5.5%.
The outperformance has been far from steady, with both indices displaying considerable volatility and sustained periods of underperformance.
Emerging economies are still at the early stages of a multi-generational ‘catch-up’ with the developed world. This process is being driven by a variety of factors – most notably the diffusion of technology, broad improvements in political governance and stability and greater reliance on market mechanisms.
Emerging market growth
The next phase of emerging market growth, however, will bring a different set of challenges for these economies: namely, how to ensure broad-based development of institutions, political structures and corporate governance in an environment where economic growth is shared by a larger portion of the population. Investors should adjust their attitude in the light of these challenges. They should be thinking more about the quality of economic growth and development as opposed simply to the quantity of growth.
Over the past 10 years, the investment community has focused on the level of economic growth in emerging markets – namely GDP growth – as the main reason for the attractiveness of these markets.
However, not much interest has been given to the sustainability of this growth or its distribution within society – both of which are key components for the long-term development of an economy.
Over the short term, aggregate economic growth is not a sufficient driver of investment performance, both on the equity as well as fixed income side. This point has been proven by various academic studies and brokerage houses over the years, but needs to be emphasised. The reasons for this are many. First, GDP growth is a backward-looking figure, whereas equity markets are the present-value of future growth and earnings.
Second, GDP measures a nation’s economic output, whereas in our globalised world, stock market indices – in emerging as well as developed markets – reflect earnings occurring around the world. Third, GDP is more closely associated with top-line figures and equity returns with bottom-line figures. Many emerging markets have not been able to translate top-line growth into bottom-line growth.
Finally, GDP gives very little sense about the distribution of economic growth within a society, and, therefore, little sense of who may be benefiting from a country’s total increase in output.
Over a longer time frame, though, there is likely to be a stronger connection between these two concepts, but investors should be wary of equating the two.
To move beyond GDP, investors should be charting the development of emerging economies using a series of different metrics, including diversification of an economy, the diverse components of economic growth, improvements in governance (both corporate and political), the development of local capital markets and investor bases, and continued improvements in human capital.
These five metrics will become an important gauge of whether an economy is developing the fundamental characteristics of an attractive and sustainable investment destination. With the post-millennial period of high across-the-board returns unlikely to be repeated, optimising returns will require a change of gear in emerging market investing and a more active approach.
The new environment requires intensive desk research, analysis and due diligence combined with flexible asset allocation. The additional quantity of preparation may deter investors hoping for the utopian world of easily earned premium returns: low risk, low cost, low volatility and high liquidity. For long-term investors who understand the changing global opportunity, returns will flow to those who combine careful preparation with the necessary quantum of boldness.
■ Why quality of growth matters Philip Saunders, John Stopford, Max King and Aniket Shah Philip Saunders (pictured), Max King and John Stopford, Investec Multi-Asset team; Aniket Shah is Programme Leader, Financing for Sustainable Development Initiative, United Nations. Back