CFA Magazine, December 2013
A strange thing is happening in global markets. On one hand, the mechanisms and directions of global trade are changing, and moving increasingly along what are known as south-south routes between emerging markets rather than the developed world. Yet at the same time, in both bonds and stocks, those same emerging markets that are supposed to be driving the world economy are underperforming their more sluggish developed-world peers – and are likely to continue doing so for the foreseeable future.
What’s happening? While few people would argue against the BRICs and other major emerging economies – Indonesia, South Africa, Nigeria and Turkey, to name but a few – it seems that all of them are undergoing a period of difficulty at exactly the same time that the US, European Union and perhaps even Japan are getting back on track. The underperformance of emerging markets might be just a passing phase, but it is demonstrably real.
First, the big picture – the biggest: global economics and trade patterns.
HSBC launched a benchmark report called The World in 2050 on these vital themes, and its considerable reach can be distilled into some illustrative headline predictions. By 2050, 19 of the 30 largest economies in the world will be countries we today call emerging economies; by then the emerging world will have increased fivefold in terms of GDP, and will be bigger than the developed world. Emerging world growth will contribute twice as much as the developed world to global growth between now and then, by which time China will be the world’s largest economy, and India third, with Brazil and Mexico in the top 10 with them. While the US and UK, with reasonably favourable demographics, won’t drift out of relevance, our top 30 economies will no longer include many European names, including Sweden, Belgium Austria, Norway and Denmark. They will have been long since pushed out by, among others, Egypt, Malaysia, Iran, Colombia and Venezuela.
Underpinning this shift will be demographics: over that period the working population will rise by 73% in Saudi Arabia just as it falls by 37% in Japan, HSBC says.
Alongside all of this, trade patterns will change too. Emerging markets’ contribution to global trade has been on the increase for many years. The World Trade Report 2013, released in July by the WTO, says that between 1980 and 2011, developing economies raised their share in world exports from 34% to 47%, and their share in world imports from 29% to 42%. But that’s only part of the story. What is perhaps more significant is emerging markets doing business with one another, rather than with the west. So the same WTO report shows that the share of north-north trade (broadly, between developed world markets) has dropped from 56% of global trade in 1990 to 36% in 2011, at the same time that south-south trade has risen from 8% to 24%. (The balance, north-south, gives us a picture of trade between the developed and the emerging world; oddly, this has stayed flat at 37%.)
It is this south-south pattern that will dominate trade patterns and economic growth in years ahead. Dr Zeti Akhtar Aziz, governor of Bank Negara Malaysia, the Malaysian central bank, calls it a new silk road: a rediscovery of the old trade routes that linked Asia, Africa and the Middle East.
One can see it everywhere. When Standard Chartered recruits new people in Africa, it places a priority on proficiency in Chinese, because China-Africa is one of the key trade corridors today, as China aims to secure resources elsewhere in the world. And when the National Bank of Abu Dhabi, under new leadership with Australian Alex Doughty as CEO, unveiled its new five-year plan, it was filled not with ambitions in western economies, but in what it calls the West-East corridor. You can see it in presentations the bank gives to investors: the corridor describes a rectangle on a map with its lines of latitude roughly on Paris and Jakarta, with its western perimeter at the West African coast, and its eastern edge just past Tokyo. Within this rectangle are a number of existing megacities – those with 10 million inhabitants or more, today including Cairo, Istanbul, Beijing, Shanghai, Seoul, Tokyo, Osaka, Manila, Delhi and Mumbai – and a huge number that are expected to have that scale by 2025, from Lagos and Kinshasa in Africa to Jakarta, Lahore and a host of Chinese and Indian cities. The idea is to expand wholesale banking within this block, focusing on growth and trade within it.
This has long been the focus of regional champions in Asia Pacific banking, most obviously Singapore’s DBS and Malaysia’s CIMB and, increasingly, Maybank. Piyush Gupta, DBS’s CEO, describes the bank as “the Asian bank of choice for the new Asia.” Today it targets a 40:30:30 split of earnings, split Singapore/Greater China/South and Southeast Asia (chiefly India). Similarly Singapore’s sovereign wealth vehicle, Temasek, abandoned a focus on the developed world in the early 2000s, and today targets a 40:30:20:10 split of assets, made up of emerging Asia/Singapore/OECD countries/other (in practice, mainly South America).
“It’s quite clear to me that trade patterns within the region are on the verge of some profound changes,” Gupta told the author last year. Through the 80s and 90s, he said, the growth of Asia was built on the supply chain of manufacturing and exports, with Asean countries sending materials into China, to be assembled and shipped out to the west. This meant that overall trade numbers might show a lot of intra-regional activity, but in practical terms, it was still reliant on a final export to Europe or the US. “What’s beginning to happen is consumption in Asia is changing,” Gupta said. “Increasingly it’s Asian companies supplying Asian consumption demand.”
It was DBS who pointed out a pivotal moment in 2010. Its economist David Carbon noted that, back in 1980, for every dollar of US incremental consumption, Asia would generate 44 cents of consumption. The figure gradually rose through the 80s and 90s, faltered during the Asian financial crisis, then grew again. In 2010 it hit $1.02: outstripping US consumption for the first time. This, DBS says, is “the biggest structural change underway in the global economy today: the shift in who generates the new demand every year.”
For banks on the ground, this is a wonderful change to grab hold of. “If you’re part of Dell’s total supply chain, there’s very little bank intermediation you do when they export from Dell Penang to Dell China, though it goes into the trade flow numbers,” Gupta said. “But when it’s from an Asian company to another Asian company, it’s a completely different role you can play as a bank. The change is quite profound.”
That pattern – growing trade within an individual emerging market (so one Asian country with another, for example) – is well entrenched. But increasingly, this trade is now inter-continental. It was interesting to see Brazil and China sign a $30 billion currency swap agreement in March, but not so surprising when you learn that China is Brazil’s biggest single trading partner. Trade between the two countries was $6.7 billion in 2003; it was just under $75 billion in 2012, driven by Chinese demand for Brazil’s resources such as iron ore and soy. Moreover, the currency swap deal was struck not for any symbolic reason, but a practical one: in the event of another financial crisis, the most important nation for Brazil to have a bilateral line with would not be the USA, but China. “If there were shocks to the global financial market, with credit running short, we’d have credit from our biggest international partner, so there would be no interruption of trade,” said Guido Mantega, Brazil’s economy minister, in March.
Equally, Asia-Africa trade is growing at a momentous pace, again with China at the vanguard. The information office of China’s State Council put out a white paper on China-Africa Economic and Trade Cooperation in August, revealing among other things the speed with which this cooperation is growing. China became the African continent’s number one trade partner in 2009 and has grown considerably since. 10 years ago the total trade volume between Africa and China was below $10 billion. In 2012 it reached US$198.49 billion, $85.3 billion made up of Chinese exports to Africa, $113.2 billion the other way around, chiefly resources. Over that time, the proportion of Africa’s total trade made up of China has gone from 3.82% (in 2000) to 16.13%. “Chinese products exported to Africa are generally of fine quality and well-priced, and fulfil the consumption demands of all social strata in Africa,” the State Council says. “With the scale of trade expanded, the structure of China-Africa trade has been improved step by step.” It pledged to “take multiple measures to promote the healthy development of China-Africa trade,” including expanding the scope of zero tariff treatment for African products exported to China, and helping African countries with their customs and inspection systems.
The impression is of growing, high-population, high-growth nations leaving the developed world behind.
But if that’s the case, then why is it that emerging market equities have underperformed developed world equities by 15% since the start of 2013 [up to September 16]? And this is not new: since 2011 the emerging world has underperformed the developed by more than 20%. And the debt side is scarcely better. According to EPFR Global, investors have pulled $22.1 billion from emerging market bond funds since the end of April. The extra yield investors require in order to buy dollar-denominated emerging market debt instead of US corporate debt is now 1.4 percentage points, the highest since December 2008. The worst of this stems from the announcement by Federal Reserve Chairman Ben Bernanke that the Fed was considering tapering its quantitative easing program: that announcement led to considerable capital flight from emerging market securities and currencies, only slightly mollified by Bernanke’s subsequent step back from that position in September. But why should capital flee the emerging world if it’s the engine of global economic growth?
Most economists and analysts expect worse to come. “I’ve been negative on emerging versus developed equities, especially the US, since the autumn of 2010,” says John-Paul Smith, global emerging market equity strategist at Deutsche Bank. “For me it’s a multi-year underperformance cycle and we are, at best, halfway through it.”
Maarten-Jan Bakkum, senior emerging market equity strategist at ING Investment Management, agrees. “We are now two and a half years underperforming, and it’s quite a surprise that a lot of people are still excited by emerging markets,” he says. He is predicting a decline to 5% growth in China within three to five years. That and a lack of reform and structural change in emerging markets are “two reasons to believe emerging markets will continue to struggle,” he says.
One reason for underperformance is not all that negative: it’s that the developed world has simply got its act together, particularly the US. And this, in turn, ought eventually to be good news for the emerging world too. “We are seeing a turnaround in the US, positive news from Japan, stabilization in China and an improvement in Europe,” says Werner Gey van Pittius, a fixed income specialist at Investec Asset Management. “It is extremely unlikely that none of that will spill over into emerging markets – which is what the market has been suggesting.”
“Globalization is permanent,” he adds. “And extricating developed world growth from emerging market growth is nigh impossible.” Any improvement in the Eurozone, he points, out, clearly has positive consequences for neighbouring Hungary and Poland, for example, as big exporters to Europe, while a long-awaited improvement in Japan has positive knock-on effects for exporters in emerging Asia. “The picture I’m trying to paint is one of a more positive growth environment for emerging markets.”
But the relative strength of the developed world is only half of the story. There are also structural problems in almost every major emerging market, and in particular the BRICs that make up so much of the emerging market universe.
Let’s take them in turn. Brazil has a troubling deficit to deal with, an overreliance on consumption, and inflation pressure, but also appears to be in an environment of corporate nationalism. “You have seen several governments take actions to the detriment of minority shareholders, shifting resources away from capital towards labour and the state,” says Smith, highlighting Brazil as the most pronounced example. There has also been social unrest there as people have protested about inequality in wealth.
Next is Russia. “Structurally I don’t like Russia and don’t see any reason to be invested-long-term: there is no positive change, the government is intervening in the economy more and more, and in large part it is state-owned or influenced,” says Bakkum. India has perhaps the worst fiscal position in Asia, with twin deficits, both fiscal and external, and a pre-election sense of paralysis in making much-needed changes to taxes and subsidies. “With slower growth and persistent twin deficits, investor sentiment has weakened and risks have risen alongside recent market turbulence.” said the IMF in a warning report in September.
And then there’s China: an economy too reliant on investment and what the IMF has called “an unsustainable surge in credit”, with problems in its banking system, questions on the reliability of data, and an inevitable slow-down in economic growth as the economic model has shifted from investment to domestic consumption. And the thing about China is that as its economy slows, it affects every other economy which was relying on it, including Brazil and Indonesia, among many others.
Along the way, the BRIC acronym has been replaced by a new and less positive one: BIITS. This stands for Brazil, India, Indonesia, Turkey and South Africa, but instead of being linked by their economic heft and promise, they are instead pulled together by their current account deficits, and for that reason, these five nations have suffered more than most in terms of market performance, and in particular in terms of their currencies.
This means, unfortunately, that apart from the BRICs, the second tier of much-admired emerging economies is also in a bit of trouble. Look, for example, at Indonesia, which a year ago was considered the market darling for emerging market investors. Now, its markets are falling, its currency in decline, and its foreign exchange reserves declining.
“The current account deterioration is driven by two factors,” says Prakriti Sofat, emerging market economist at Barclays Capital. “The first is an unfavourable terms of trade shock, given that commodities make up nearly 70% of total exports. The country has been facing this headwind for the last 12 to 18 months and will continue to do so, given structurally lower growth in China,” particularly since what growth remains in China is increasingly driven by consumption rather than resource-fuelled investment. The second factor, she says, is on the import line: refined petroleum products are a key import for Indonesia, and since the government subsidises the fuel price, “volumes do not adjust to changes in global oil prices or weakness in the rupiah.” That means the government takes the hit on the fiscal side.
Moreover, even if tapering has had a reprieve in recent months, it’s on its way eventually. And judging by the reaction of the markets between May and September, when it comes it will hit emerging markets badly again. So there is worse to come. These days, when DBS puts out a benchmark report, it is boasting not about Asian trade links, but warning about trouble ahead. “Current account deficits, capital outflow, collapsing currencies – is Asia headed for 1997 all over again?” asked David Carbon in his latest report in September. “Absolutely. We’ve been charting Asia’s progress toward 1997 for five years and it’s closer than ever.” In fact, Carbon doesn’t say Asia must go into another regional crisis, and can certainly avoid one by keeping a lid on leverage. But he singles out India and Indonesia as problem areas, and it shows how the debate in Asia has changed that such a report should come out at all.
But it is necessary to take a step back. None of these changing dynamics alters the fact that these markets will have the highest economic growth rates in the years ahead, nor that their slice of the global pie is going to increase in every respect – wealth, market weight, trade, everything. “When emerging markets were first described as an asset class they were about 3% of the weighting of the MSCI equity index,” says Archie Hart, an emerging market equity specialist at Investec. “Now, it’s about 13%. And if you look forward, while we are not sure how fast, we can argue that the contribution will continue to rise over time.”
It’s a question of time and perspective. Speaking on Indonesia, but in comments that would equally fit India or many other major emerging economies, Deutsche Bank economist Taimur Baig says: “The situation is serious, but we need to be careful about drawing a line between medium term fundamental strength and short-term weakness. Our view is that Indonesia is structurally strong, but cyclically negative, and we have been saying this for a while. It is possible to be long term bullish and short term bearish.”
Additionally, a changing economy doesn’t necessarily mean a bad economy. Carbon at DBS says of his predictions of a new 1997 in Asia: “If that sounds ominous, it shouldn’t.” Changes in Asia, he says, reflect what many global economists had called for for years: a wish that Asia would stop running surpluses and the west should cut its deficits. “That is now happening and, with the important exception of India, that’s pretty much all that’s happening – it’s a benign and welcome development. Asia, as a developing region, is supposed to be running deficits, not surpluses. It’s supposed to be borrowing from the rich countries, not lending to them.”
For the investor, then, it’s all about timing and balance. The prospects in the emerging world continue to be the best when one considers all the big-picture themes about demographics and potential growth, but there is likely to be another year or more when developed world assets perform better. Timing how and when to shift resources among those two camps, developed and developing, will be key.