Are Emerging Markets Still "Emerging?"
Emerald Asset Advisors
By Team
March 4, 2011
Political unrest in Egypt, Libya, and elsewhere in the Middle East, along with surging food prices around the world, has provided fresh reminders of the inherent risks of investing in emerging markets. Indeed, while the U.S. stock market has been inching steadily upward in recent months, emerging markets have been struggling. Year-to-date through February 28, the MSCI Emerging Markets Index is down -3.79%, while the S&P 500 Total Return Index has gained 5.88%.
Despite this near-term uncertainty, we believe the long-term outlook for emerging markets is quite positive. With fast-growing populations, favorable demographic trends, technological and political progress, we believe that growth opportunities abound. In our view, an allocation to the emerging market space can be a valuable piece of any global or international-based equity portfolio.
Rather than applying a broad-based, blanket emerging market position, however, we strive to capitalize on certain compelling themes that we see developing within the broader emerging markets arena. In particular, we believe the rise of the middle class consumer is a major trend that will yield significant opportunities over the long-term.
Demographic Trends - and a Rising Middle Class - Bode Well
In the past, most emerging markets economies were at the mercy of multinational corporations looking to escape high labor costs and environmental oversight in their home countries. These companies built factories overseas and shipped finished goods back to developed nations for consumption, while the foreign workers were paid subsistence wages.
While cheap labor is still a driving force in many emerging markets economies, China, India, and Brazil, among others, appear to have reached a tipping point where their economies are no longer dependent on foreign capital and exports alone. Twenty years ago, food and other necessities consumed the majority of worker's paychecks in China. Any money left over was set aside to cover emergencies, because the government provided little in the way of a social safety net. Today, improved working conditions, rising wages, and increased urbanization are enabling millions of Chinese to buy their first cars and homes. This has propelled spending on furniture, appliances, and other household necessities.
Similar to what occurred in Japan decades ago, a new consumption culture is on the rise. Department stores and big box retailers are springing up, replacing the traditional mom and pop stores. Essentially, the trends that took many decades to materialize in the U.S. Europe and Japan are now taking shape in China, India, Brazil, and other emerging markets.
The population demographics bode well for continued growth. Unlike Europe and Japan, which are grappling with aging populations, many emerging markets nations have fast growing, youthful populations. The ratio of 20-29 years olds vs. 40-49 year olds is much higher in Asia than in the developed world. These younger people spend more and save less, which further fuels economic growth. In all, the 10 largest emerging markets have more than half the world's population but only about one-third of the world's GDP.
Opportunities in China, India, and Beyond
Nowhere are these trends more evident than in China, which last month officially surpassed Japan as the world's second largest economy. This is partly a function of China's population of 1.3 billion people. Nevertheless, today more than 100 million Chinese manage to survive on less than $2 a day. Per capita GDP is still just $4,300, less than 10% of the U.S. rate.
While the majority of the Chinese population is poor today, many will move up into the middle class in the years to come. The Chinese middle class is expected to grow from 48 million households in 2010 to 134 million by 2020. Today, the Chinese already buy more cars and mobile phones than Americans do. Proctor & Gamble expects to add another 270 million middle-class consumers in emerging markets over the next decade. That's roughly the size of the entire U.S. market.
Other emerging markets nations are also experiencing a burgeoning middle class. In India, McKinsey Consultants expects the middle class to reach 580 million people by 2025. In Indonesia, the number of households with annual disposable income of $5,000 to $15,000 is projected to rise from 36 percent today to 58 percent in 2020. The number of Brazilians who fall into the middle class is expected to grow from 103 million to 130 million by 2014, or around 56 percent of the population.
You've Come a Long Way Baby!
It's easy to associate emerging markets with extreme volatility and political upheaval, as several crises have tested investors' faith in these markets over the past two decades. In 1997, we had the so-called "Asian Contagion" crisis among Asian banks that led to widespread problems and severe stock market losses. In 1998, Russia defaulted on its bonds. More recently, the MSCI Emerging Markets Index plummeted 53% during the financial crisis of 2008.
Each of these crises had their roots in debt financing, which became problematic when global financial institutions reversed the flow of capital into developing nations. Over the past decade, however, many of these nations have implemented structural reforms and cleaned up their balance sheets. Unlike many Western nations, many of these countries are not saddled with overleveraged governments and consumers, deflating real estate bubbles, and graying populations. The percentage of emerging market debt rated investment grade has risen from 5% to more than 50% over the past 20 years.
Emerging markets were previously almost entirely dependent upon foreign capital to finance their export-driven economies. But with the emergence of sizeable domestic markets for goods and services, the U.S. and the West are no longer the only game in town. South Korea and Brazil both export more goods to China than to the U.S. In fact, in 2008, total consumption in emerging markets nations surpassed that of the U.S. for the first time.
For more evidence of the maturation of many emerging markets, just consider what happened during 2008. While economies in the U.S., Europe, and much of the developed world fell off a cliff, many emerging markets economies continued to expand at rates that we here in the U.S. can only dream about. From its peak of 13% GDP growth in 2007, China's economic growth "fell" to 6% in the second quarter of 2009. India's GDP growth fell from 12% to 9% during the same period. Both have since rebounded again and Goldman Sachs projects 2011 GDP growth of 10% in China and 8.7% in India.
Despite the relatively minor damage to emerging markets' economies, their stocks did not escape 2008 unscathed. The MSCI Emerging Markets Index's 53% decline in 2008 was worse than the 37% decline in the S&P 500 Index. But emerging markets stocks bounced back faster and higher over the two-year period of 2008 - 2009, with a total decline of -16.7%, versus a -20.3% decline in the S&P 500 Index.
Risks Remain
While we believe the long-term outlook for emerging markets remains strong, the ride always has the potential to be bumpy. As recent events in Egypt and now Libya have demonstrated, political unrest can create a difficult operating environment for companies. Corporate governance and securities market regulations are also less stringent in emerging markets, making it more challenging for managers to avoid problems.
Rising prices for food, oil, and other commodities could spur hyperinflation and political unrest. And there's always the challenge of currency fluctuations and volatility caused by traders quickly entering and exiting these markets.
Given all the dynamics at play and the many moving parts, our approach has centered on selecting active managers who are immersed in the emerging markets arena. These managers have demonstrated an ability to capitalize on the opportunities engendered from the economic and demographic shifts. In addition, we believe that having the flexibility and willingness to actively hedge at the macro level is a critical tool to help navigate through the risks that typically characterize this space.
Our Approach
Our primary hedging mechanism has been non-leveraged inverse ETFs, which have become more readily available as the market for ETFs has evolved. While we generally prefer to be fully invested, we have also used cash as a defensive weapon during times of heightened market uncertainty. We believe the hedged approach we have employed has historically served us well in emerging markets, and in turn has benefited our overall Global Equity Strategy (Global Cycle).
We believe that multiple factors are driving emerging markets on a rapid course that will someday lead them out of the "emerging" stage of their development. This evolution will have a powerful impact on the rest of the world. We expect that it may bring an interesting series of changes to the global marketplace, which may alter the investment landscape and heighten the role that these "emerging" markets once played. We continue to have exposure to this area, but with the same hedged approach that characterizes our general style of portfolio management.
The information herein has been obtained from sources believed to be reliable, but Emerald Asset
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