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Emerging markets remain prone to volatility despite experiencing a prolonged period of economic growth. Sharp slowdowns in Brazil, Russia and India have led investors to become more discerning about the economic fundamentals in the BRICs and other countries. These developing markets have largely benefited from monetary stimulus policies put in place in developed economies in the wake of the 2008 financial crisis, though there were some exceptions like Brazil that have struggled with currency appreciation as a result.
The scale of the stimulus was massive and unprecedented, pushing official interest rates down to record lows in major economies, including the US. As a result, capital flooded into emerging markets, lifting equity prices and bond prices on a tide of money from every corner of the global economy. That tide began to recede in June 2013 after chairman of the Federal Reserve (the Fed), Ben Bernanke, mentioned that the central bank was considering tapering its latest bond-buying programme. Emerging-market equities sold off, bond prices dropped and some significant emergingmarket currencies tumbled. Simultaneously, economic growth throughout emerging-market economies began to slow. Today, investors are understandably nervous about what will happen next in emerging markets, especially when the Fed does end its stimulus programme, something that could occur as early as 2014.
Figure 1 // Fed tightening has pulled equity investment from EMs
Investors have been losing confidence in emerging markets, although some interest is returning
Stockmarket indices, December 2011=100.
Source: FTSE All Global All Cap, FTSE All Emerging Market All Cap
In this report, we examine the outlook for emerging markets in the context of global economic recovery. We draw on insights of emerging-market investors as well as the views of economists about what's next for developing economies. We also draw on our findings from the Search for growth white paper, sponsored by BNY Mellon, that discusses investor sentiments about the global economy using responses to a January 2013 survey of 730 institutional investors and executives.
China, of course, figured prominently in investors' outlooks for emerging economies at the start of the year. Despite slower growth, investors are encouraged by the Chinese government's efforts to create a dynamic, internally driven economy that can withstand weaker demand from developed economies. They are also taking it upon themselves to look more closely at the emerging-market asset class to determine where the greatest value lies. In this paper, we will discuss the new ways that investors are classifying and thinking about emerging markets.
Who took the survey?
The survey questioned 730 executives worldwide. The respondents were based primarily in North America (29%), Asia-Pacific (29%), and Western Europe (26%), with the rest from the Middle East and Africa, Latin America and Eastern Europe. While the largest number of respondents came from the US (22%), 7% came from the UK and Canada, 5% from India, and 4% from each of the following countries: Australia, Brazil, China, Germany, South Korea, Japan and the United Arab Emirates. In total, investors and executives from 73 countries responded to the survey.
In terms of seniority, 52% were at the "C-suite" level, 23% at the director level and 26% at more than $500m per year, and 50% were from companies reporting less than $500m in annual revenue. The overwhelming majority (73%) of respondents came from the financial industry, with 11% from retail banking, 10% from asset management, and 9% from diversified banking institutions. Corporate banking, private equity/ venture capital, financial services consulting and non-life insurance each represent 8% of respondents. A lesser number of responses were spread across other
Chairman Bernanke's comments in June 2013 set off a chain reaction around the world that adversely affected emerging economies. In the second half of the year, the developed-countries equity index outperformed the emerging-markets equity index. This relative outperformance of developed markets was the greatest since the Asian currency crisis of the late 1990s. Countries with large deficits — like India, Indonesia, South Africa and Turkey — saw currencies depreciate, thus magnifying their economic problems. Commodity prices also slumped on the perception that demand was slowing from the developing world. Emergingmarket commodity producers such as Brazil and Russia were directly affected.
Figure 2 // What went IN to emerging markets is now coming OUT
US Treasury yields have climbed as emerging market bonds have fallen 10-year US Treasury bond, % (left scale)
JP Morgan Emerging Markets Bond Index Plus, index, 1993=100 (right scale)
Source: Haver, JP Morgan
Slower growth in China, caused largely by recession in the US and Europe, has fed investor uncertainty. As Stephen Roach, a senior fellow at Yale and expert on Asia puts it: "China is the dominant economy. As China goes, so goes the broad group of emerging markets."
Investor fears about China's slowdown have been somewhat allayed by the Asian giant's new pro-business, consensus government. In November, major policies were introduced to redirect the Chinese economy away from an export-driven, manufacturing powerhouse towards a consumer-driven, service economy. "It's a fascinating turning point in China," says Mr Roach. "The old model, focused on exports and investments, left China exposed to internal imbalances and external risks. They understand they need new sources of internal demand and they're putting in place the policies to achieve this."
Key features of the new policy initiative include a requirement that state owned enterprises put aside some of their profits to help fund the social safety net and an easing of the one-child policy. "The social reforms are very encouraging," explains Mr Roach. "The West is very biased in its assessment of China and doesn't appreciate the significance of the changes occurring. Income will increasingly be spent. A consumer-led, services-led economy is more compelling than ever," he adds.
Yet the prospect of tapering of the US stimulus remains a major worry for investors. "There are countervailing pressures on emerging markets right now," explains John Rutledge, chief investment strategist at Safanael and former White House official. He adds, "It's the Fed story versus the Chinese government story. Which one is stronger will determine what happens in the year ahead. The big-swing story for emerging markets is capital flows. The big worry is that interest rates will rise in the US and capital will flow out."
Positive outlook emerges
At the start of 2013, the vast majority of the 730 global investors surveyed were bullish on emerging markets but increasingly concerned about the future. Some 57% of investors said they thought emerging markets were overheating. After the sell-off prompted by Chairman Bernanke's comments in June, though, some of the steam from emerging markets has dissipated and investor interest is reviving.
As global investors' attention returns to emerging markets at year's end, the biggest threat remains the pending tapering likely to take place under the new Fed leadership of Janet Yellen. "Risks have sharpened and will not ease in 2014," remarks Steven Leslie, analyst with the EIU. "The main cause of this is the highly likely rotation in global interest rates that has begun and will carry on in the near future. With the Fed set to taper its quantitative easing [QE] in the coming year, US interest rates will rise and will attract liquid investment from emerging markets."
It remains to be seen just what the consequences will be for emerging markets. Will Ms Yellen take a different approach to tapering than that proposed by Mr Bernanke? If the central bank moves more slowly, might tapering have less of an impact on capital flows? Not all emerging-market economies suffered during the June sell-off, and investors are expecting wide variations again. Those with stronger economic fundamentals, current account surpluses or small deficits-including China, Taiwan and South Korea-are expected to perform better.
Arjun Jayaraman, co-manager at Causeway Emerging Markets Fund, recommends that investors prepare for tapering by focusing on stronger economies such as those of Korea, Taiwan and China instead of India, Indonesia, South Africa and Turkey, which are more vulnerable to a currency crisis. Investors have become increasingly wary of India, mainly because structural reforms have lagged and corruption remains rampant. "I'm very discouraged about India's progress on structural reforms," says Yale's Mr Roach. "It's trapped in a quagmire of political corruption. The Indian economy is lacking in policies that will encourage saving, infrastructure investment and open markets to foreign direct investment. Until that changes, the outlook for growth in India is disturbing."
Other emerging economies, such as Russia and Brazil, share similar problems. When growth was booming, structural changes lagged, but investment still flowed in. As growth has slowed, investors have become more concerned about structural reforms and internal measures to boost demand in these economies.
While the growth gap between the developed economies and emerging economies is narrowing, investors still expect stronger growth in emerging markets, which are being driven by China. "I don't expect China to bring back 10% growth rates, but the 7.5% to 8% growth level will be solid," explains Mr Rutledge from the investment firm Safanael. He adds, "The new government in China is consensusdriven, pro-business, pro-growth. They are trying to do things to improve stability in China by addressing people's concerns." In addition, strengthening economies in the US, Europe and Japan will increase demand for emerging-market exports, boosting growth further in emerging economies.
Figure 3 // Hitting a BRIC wall? The stars are no longer shining
Not just cyclical problems; structural issues as well
Quarterly real GDP growth % change year on year.
Source: Haver Analytics
In other words, despite the looming Fed tapering, investors are still upbeat about emerging markets. The EIU is forecasting a positive outlook for them in 2014 and well beyond. According to Mr Leslie, the EIU anticipates real GDP growth (at PPP) of 5.2% in non-OECD economies in the coming year, compared with a much weaker 2.1% in OECD economies. "We foresee a strengthening in both types of economies through 2018 but think that the non-OECD economies will continue to enjoy an advantage of about 3 percentage points of additional GDP across the period. So, in 2018, for example, we see them at 5.5% and 2.4%, respectively."
Regardless of whether capital flows in or out of emerging markets in the year ahead, investors are looking more closely at the asset class to determine where the greatest value lies. Investors are also looking into new ways of categorising and thinking about emerging markets. "We tend to clump things together we don't understand," admits Mr Rutledge of Safanael, "but as investors learn more about individual countries and markets, they will start to talk about emerging markets differently."
As investors become choosier about which emerging-market economies to invest in, the concept of an "emerging-markets asset class" could possibly break down. EIU interviews with institutional investors in December 2013 reveal that most believe it is too early to discard emerging markets as an asset class, though they admit to investing according to different characteristics within the broader category.
Mr Jayaraman of Causeway Emerging Markets Fund, for example, has started classifying emerging economies into different sectors: commodities and energy, IT, consumer staples, and healthcare. Different regions tend to be more heavily invested in different sectors, he finds. For instance, Asia tends to be IT-oriented, Russia and Brazil are more focused on energy and commodities, while India and China are growing healthcare providers. Mr Rutledge agrees: "There are big differences between resource-rich emerging markets-South Asia, Persian Gulf and Africa-and technology producers like Taiwan, South Korea and Singapore." He adds, "Latin America is heavily resource-oriented but with a huge US investment presence."
The EIU's Mr Leslie explains it this way: "They can be basket cases pursuing poor polices like Argentina and Venezuela. They can be in abject poverty or relatively well-off places such as China, Malaysia and Uruguay. They can be resource producers, manufacturers or service centres. They can be dependent on foreign financing or selfsufficient, even closed economies." He explains, however, that the largest bloc of emerging markets-countries with middle incomes between $5,000 and $15,000 (at PPP) per person that enjoy healthy growth prospects-were the least hurt by the 2008 crisis. While the largest of these includes Brazil, Russia, India and China, he also adds Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa. "It probably still makes sense to talk about EMs as a class albeit with caveats," he says; yet, he admits, "that may not be true in the future."
So, what's next?
Despite real politico-economic vulnerabilities in key developing countries and the possible effects of Fed tapering, these economies are still well-positioned in the global economy and will likely continue to grow. Leo Abruzzese, EIU's global forecasting director, believes that as it becomes a middle-income nation, China won't grow as fast but it will add more to GDP in absolute dollar terms than when it grew at an annual rate of 14%. Many emerging markets like India, Brazil and African countries are endowed with large young populations and have great growth potential should they manage much-needed infrastructure reform, according to Mr Abruzzese. Moreover, recovery in developed economies will boost emerging markets in the medium term-largely by supporting emerging market exports. And promoting a growth model based more on domestic consumer spending and a lower volume of exports-as China's new government is doing- should create a foundation for more sustained growth moving forward.
The looming Fed tapering creates some uncertainty in the short term. Although, at the moment, the soon-to-be Fed chair appears to be more concerned with boosting employment than tapering. Today, investors are still keen on emerging markets and are investing broadly in them, though planning to keep a cautious eye on tapering during the next year. But, as Mr Jayaraman points out, tapering is a sign that the US economy is doing well, which is actually good news for export-driven emerging markets.
The biggest challenge for emerging-market investors is weathering abrupt changes in capital flows. If tapering is smooth and slow, then capital flows will not be disruptive. Yet, since the Fed's bond-buying programme has been unprecedented both in its scale as well as substance, no one knows how tapering will affect global financial markets. Emerging markets remain risky for a reason-an urgent need for structural reforms, widespread corruption and a lack of transparency still plague most of them. If there's panic in emerging markets, no one wants to be the last one holding Turkish stocks or South African rands. At their best, emerging markets offer an exhilarating ride up and, at worst, a white-knuckle descent. For now, investors should enjoy the relative calm in these markets at year's end. It might not last long.
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