Since their stellar returns in 2007, emerging equities have been touted as the next big thing after the US technology miracle-turned-bubble in 2000. The credit crisis and the collapse in global financial markets in 2008 put paid to this mostly self-serving talk. The spectacular revival in asset prices, particularly in developing countries, has again revived the talk of emerging markets driving investor returns in coming years. This is due, in large part, to the success of the revival of growth in China. Doomsday predictions of China’s growth collapsing under the weight of the slump in aggregate demand in the West and its own rising unemployment turned out to be just that in 2009.
Hence, the theme of emerging economies and markets decoupling from their Group of Seven (G-7) counterparts has revived again. This decoupling hypothesis is premised on the relationship between faster nominal growth anticipated in developing economies, corporate earnings and stock market performance. In other words, there are two implicit hypotheses here: one is that growth in the developing world is independent of growth vicissitudes in the G-7 area and that such high growth would necessarily translate into higher returns for investors. In this column, we concentrate on the second of these two hypotheses.
Professors Elroy Dimson, Paul Marsh and Mike Staunton of the London School of Economics, in their Annual Investment Returns Yearbook 2010, take a close look at this issue and come away relatively unimpressed. They find that gross domestic product (GDP) per capita does an excellent job of discriminating between emerging and emerged markets. Historically, $25,000 effectively marked the boundary between emerging and developed markets.
Using this criterion, they find that only seven of the 38 countries with equity markets in 1900 changed their status over the following 110 years. Five markets moved from “emerging” to “developed”. Two moved from “developed” to “emerging”. Seventeen remained “developed” and 14 stayed in the “emerging” category 110 years later. So, the first inference is that emerging markets can stay that way longer than investors realize.
The second key message from their study is that higher economic growth need not necessarily provide superior investment returns. The reasons are many. We would list a few here. Growth in each country’s real economy need not be the same as growth in stock market capitalization. The professors point out that, only two decades ago, Germany and Japan were cited as premier models of how GDP could grow through bank and not stock market financing. Second, even if market capitalization rises, emerging market companies might be non-investable or have limited free float. Third, there is no clear correspondence between a company’s nationality and its economic exposure. Emerging market companies that trade internationally might be dependent on growth in the developed world. Similarly, multinationals in leading economies might rely on growth in emerging countries.
But statistics can be deceptive. One needs to look at the broad picture. Between 1970 and 1989, Japan’s nominal GDP grew at a compounded annual rate of nearly 10%. The Topix index grew at a rate of 15%. Between 1989 and 1995, Japan’s annual average nominal GDP growth rate sagged to 2.7% and the Topix index shed 9.6% annually, on average, in the same period.
Let us take China. Based on International Monetary Fund data, between 1990 and 2008, its annual nominal GDP growth was 16.5% and the annual return in the Shanghai Composite index was 15.9%. Again, the correspondence between broad economic growth and market capitalization trends is impressive, concrete and unassailable. On that basis, it is reasonable to argue that the likelihood of faster nominal GDP growth in Asia enhances the return prospects from their stock markets.
Hence, the case for emerging markets based on their better growth prospects appears empirically well founded. The missing link is the valuation argument. Clearly, in October 2008 and in March 2009, Asia (ex-Japan) stocks were a lot more attractive than they are today. The good news, however, is that they are nowhere near as overpriced as they were in October 2007.
What is the trigger that investors need to re-recognize the potential in emerging markets? That will come if leading nations in Asia signal that they have put behind them, “business as usual”. For instance, Indonesian politics must embrace reform rather than resistance, the Indian government should adopt discipline rather than accept deficit and the government in China should opt for (currency) appreciation rather than (reserve) accumulation.
More than conviction, circumstances are pushing each of these three countries in the right direction. Historically, for the most part, Western nations have not reformed themselves out of conviction either. The ongoing deleveraging in the developed world is the “crisis” that would push emerging nations to stand up on their own two feet.
Bare Talk has more faith in the persuasive powers of crises and circumstances than that of convictions of governments to usher in necessary changes. On that basis, investors should be opportunistic buyers of emerging market equities.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org