Positive outlook for emerging markets

Roundtable panellists

Moderator: Anthony Rowley, Tokyo Correspondent, The Business Times

AFTER several decades of being stars in the investment firmament, emerging markets appear to have fallen to earth, with China suffering the most spectacular burnout. The World Bank noted recently that emerging market growth has halved in the past few years and that this is unlikely to be a temporary phenomenon. Under certain scenarios, emerging market growth could even come to a "stop", the bank suggested. Meanwhile, the Institute of International Finance says that emerging markets are "ageing prematurely" and are now past their best. The Business Times convened its panel of leading economists to look at what is going on and to tell what it all means for investors.

The Business Times: We have some of the top names from the Asian and global investment community here to discuss one of the most burning issues of the day, which is - what has happened to the emerging market "miracle"? Hung Tran, the IIF has claimed that emerging markets are ageing prematurely. Why?

Hung Tran: Emerging markets have shown many signs of diminishing returns on economic inputs, similar to mature economies but at an earlier stage of industrialisation and per-capita income growth. For example, high debt levels - these total US$58 trillion or about 200 per cent of GDP - and a declining marginal contribution of debt to GDP means that one additional dollar of debt produces only US$0.40 of GDP compared to US$0.75 in 1995-2006. Productivity growth has slowed from 3.5 per cent per year 2003-07 to just 0.9 per cent in 2011-15, excluding China and India. Labour force growth has also slowed in the EMs and all this reduces potential growth rates.

BT: Mark, as "Mr Emerging Markets" what do you say to those charges?

Mark Mobius: I'm still very optimistic that the future lies with the emerging market. On average emerging countries have a real growth rate of about 4 per cent. The two most populous nations in the world, China and India, are growing at 6-7 per cent. It would be very difficult to imagine emerging markets coming to a halt.They are benefiting from advances in technology and communication which are resulting in even higher productivity. With such high growth rates it's difficult to argue that emerging markets countries are ageing prematurely or are past their best. Most of them have very young populations who are entering the most productive years of their lives.The fundamentals of emerging markets have significantly improved over the last decade. Foreign currency reserves in emerging markets have steadily risen, and emerging markets have in general much lower levels of public debt in relation to GDP. In spite of recent weakness, emerging markets still make up over half of global GDP.

BT: But the two dozen or so emerging markets - twice that number if you include so-called "frontier" markets - obviously do have problems. Are these cyclical or structural?

Mobius: Any problems that emerging markets and markets in general have are cyclical and structural. There is no question that prices of commodities tend to be cyclical. However, most problems emerging markets face are structural in nature such as waste of resources, government corruption and so on.

Tran: During the emerging market slowdown over the past five years, structural factors seemed to dominate.The external environment has deteriorated markedly since 2011. From a peak in that year, commodity prices have fallen by more than 50 per cent after previously rising by 80 per cent over 1999-2011. Historically the downswing of such commodity super-cycles lasts up to more than 20 years following a sustained upswing. The decline in commodity prices may have more time to run, reflecting subdued demand and plentiful supply. Emerging markets are also hurting from the slowdown in world trade from about 7 per cent per annum in the years before the global financial crisis to around 2 per cent now. This slowdown in world trade growth has also slowed emerging market growth and made currency depreciation much less beneficial in reviving export growth.

BT: Kenneth, your thoughts please.

Kenneth Courtis: There are vast differences among emerging economies but they are all contending with downward cyclical pressures and longer term structural transitions. During the past three decades as debt-driven growth came to characterise mature economies, high investment, high savings and export-driven growth strategies characterised the fastest growing emerging economies. This was particularly the case in East Asia. A second group of emerging economies based their growth on the rapid expansion of commodity exports, which in turn financed import-driven consumption. With the bursting of the Bush Bubble, starting a decade ago, banking and public finance crises across Europe and Japan's continuing weakness, emerging economies have hit the wall, with the result that they are struggling to reposition themselves - with little choice but to move to domestically-focused growth strategies.

BT: William, as an ex-US Treasury official, what's your perspective?

William Thomson: Many emerging economies are now barely recognisable from those of 25-30 years ago. Living standards have improved and growth rates must decline to reflect the slower growth of world trade and newer challenges these now more sophisticated economies face in terms of physical infrastructure and the soft infrastructure of legal systems, corruption, education, health and social security. Regardless, the growth rates of these economies should still be greater than the developed economies with their problems of debt and demography.

BT: Robert and Chris?

Robert Lloyd-George: I believe the term "emerging markets" is no longer a useful description of an asset class, which has been divided into regional and sector groups with very different trajectories. Among the so-called BRICs (Brazil, Russia, India, and China) Brazil and Russia have been severely punished for being commodity heavy economies while India and China are still enjoying good economic growth. This is also true of the frontier markets such as Africa and Central Asia which are feeling this severe downturn of commodity prices. I think that the long-term cycle of commodity prices, which are likely to stay down for 10 years, is the major factor in the performance of many emerging markets. The problems are not structural but are of a long-term nature, even if they are cyclical.

Christopher Wood: I believe the problems of emerging markets are more cyclical as a consequence of slowing global growth, a strong US dollar and the current renminbi devaluation scare. While some of the emerging market economies may be more commodity geared, Asia in aggregate is a massive beneficiary of lower oil prices and Asia now represents 7 per cent of the MSCI emerging markets asset class. So the continuing perception of emerging markets as a commodity-driven asset class is becoming increasingly divorced from reality. While economic growth in the emerging markets has slowed in the past few years, they still accounted for 75 per cent of the increase in world nominal GDP in US dollar terms between 2009 and 2014.

BT: Let's look at China. It seems that "the bigger they are, the harder they fall" so far as the emerging market downturn is concerned. Mark, how serious is the China slump for emerging markets as a whole?

Mobius: China does represent a large part of global trade but is not dominant. For example it represents about 11 per cent of world exports while the US share is 10 per cent and Germany's 8 per cent. Those countries together only add up to about 29 per cent but there are many more players. Of course, a slowdown in China would have some impact but it would not be disastrous.

Courtis: While people are wringing their hands in anxiety about China, I am much more optimistic and confident that China will not only pull off the vast transition which she has now engaged in, but that the transition is creating fascinating new business models and investment opportunities. Healthcare, technological innovation, entertainment, digitally driven services are some examples. China, and a number of other economies of Asia, such as Singapore, Taiwan, Hong Kong, are major beneficiaries of the dramatic drop in commodity prices. For China, the vast savings from lower commodity prices is partially absorbing the shock to the economy of the contracting old industrial sector, and accelerating the shift to a more consumer demand-centric economy.

Lloyd-George: China's demand for iron ore, copper, rubber, cement, oil, gas and all the other required basic materials for its infrastructure buildup has now been substantially reduced and discounted in share prices. The effect on world trade is being transmitted mainly through oil prices - down 70 per cent - and the impact of that has on demand among Opec countries in the Middle East and Africa and the reduction in capital spending by major oil companies. World trade is going to continue slowing down as reflected in lack of demand for shipping capacity.

BT: How far are the problems of emerging markets a result of aggressive monetary easing by central banks in advanced economies (and now reversal by the US Fed) given the swings in global capital flows this has caused?

Lloyd-George: The initial response to increased monetary stimulus was for much of the excess capital to make its way to higher growth and higher return economies, for instance, India with rupee deposit yields of 8 per cent was more attractive than euros or US dollars with zero cash yields. But as the move by the Fed to increase rates strengthens the dollar, there has been an outflow of money from emerging market currencies and fixed income markets.

Thomson: Developed country QE (quantitative easing) boosted the flow of fast money to the emerging economies and some of that is returning home as liquidity tightens as a result of Fed actions that are only partially offset by the BOJ and the ECB. Emerging market currencies, growth rates and stock markets have all been under pressure. That almost certainly has further to go.

Mobius: As indicated by reactions to the QE policies of the US, there was definitely an impact. The problem with those policies is that the banks which receive the liquidity are using it to strengthen their balance sheets rather than engaging in lending - so the incremental money coming from central banks is not having the impact that it normally would have.

Wood: The Fed tightening scare, and the resulting US dollar strength last year, have already had a negative impact on capital inflows into emerging markets. The issue now is whether the Fed will continue to raise rates in 2016, or whether it will resume easing during 2016. My view remains that the negative market action in credit markets will force a U-turn on US monetary policy during 2016. The commencement of Fed tightening, against a backdrop of a rising US dollar and falling commodity prices, means a stress test for the carry trade which has been driven by seven years of zero rates and the resulting global search for yield.

BT: You all seem to agree that emerging markets do have problems. So what can be done about these?

Tran: Emerging markets need to implement strong and focused policies to reduce imbalances, relieve infrastructure bottlenecks and realise structural reform to enhance potential growth rate of their economies. Only a few of them have adopted such policies, and even for those such as India and Mexico, there are problems with implementation and economic dividend has been slow in coming. Many EMs have encountered serious political and policy difficulty domestically, adding more uncertainty to their prospects.

Lloyd-George: I'm optimistic that emerging markets can have a fairly good recovery before the end of 2016, despite the unpromising start to the year. The China risks have been exaggerated, especially the devaluation of the renminbi, which has been really quite modest. Goldman Sachs' economists predict a modest recovery in emerging markets growth within this year, after five years of decline. Inflation should also pick up slowly, as we expect that oil prices will bottom out in the first quarter, near to the current level of US$30/35 a barrel. This is probably the most important single indicator of confidence and capital spending intentions. That is why I do not expect a systemic emerging markets crisis. I believe emerging market equities will outperform US equities this year, given a more stable commodity price background, and peaking of the US dollar. One very interesting forward indicator is the gold price, which has rallied in the past few weeks.

Thomson: Everything is cyclical in the markets even within a long term growth story; that remains the case for the emerging economies. Value has not been paid sufficient attention when monetary policy has remained ultra-loose but emerging markets continue to offer some good value opportunities in terms of higher dividends and lower price earnings ratios compared with developed markets. I believe their medium to longer term prospects are bright and I would want to continue to monitor these markets to look for a good re-entry position or to add to existing holdings.

BT: What are the implications of all this for investors and for portfolio allocation?

Courtis: Emerging market assets today are cheaper than they have been at any time in the past decade. Increasingly there is value appearing in many sectors. But with turmoil in commodity markets, and tensions building in financial markets as the US continues to tighten, emerging equity and bond markets are on course to become still cheaper. Deep value combined with a decade or more of large scale growth enhancing infrastructure investments, particularly across Asia, will create a unique investment opportunity, equivalent to what we had following the emerging markets' crash some two decades ago. As we know well, to generate superior investment results, investors need frequently to invest against the consensus, to buy when there is fear gripping the markets, and to sell when greed becomes the theme of the day.

Lloyd-George: Our preferred region is the Indian Ocean area including India, Pakistan, Bangladesh, Sri Lanka and Myanmar, and also Asean including Vietnam, because we see demographic growth as well as political stability, relative immunity to any slowdown in China, EU or the USA, and benefits from weaker oil and commodity prices. That is why I believe that it is better to take a regional approach rather than taking the whole asset class of the emerging markets, as an asset allocation decision.

Wood: There will be a huge buying opportunity when markets realise that the Fed is going to resume monetary easing and that China has not lost control of its currency.

Thomson: The present situation has echoes of 2007 when the markets were rattled by the emerging subprime mortgage debacle. With the Fed embarking on an interest rate rise cycle, liquidity is draining from lower value peripheral markets, especially junk bonds. Trouble could emanate from the shale oil junk bonds which could transmit to emerging markets currencies and corporate bonds as well as create problems in the global banking system, to say nothing about the Chinese banking system or increased geopolitical problems from the horrendous situation developing in the Middle East. It is shaping up to be a challenging year but the challenges will bring opportunities. The time to buy big oils must be close, war could accelerate that. Likewise, gold should have a good year and the gold miners are so bombed out that they represent value and relatively low risk.

READ MORE: Emerging-market slump set to continue this year: IIF