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EM Growth Needs to Recover to Pre-Crisis Levels

Updated: May 18, 2022

The volume of opinion surrounding emerging markets can, at times, seem deafening. For simplicity’s sake, I will discuss just two key points. The first relates to the asset class’s systematic returns, the other to its non-systematic, or idiosyncratic, returns. My conclusion is that the performance of emerging markets generally may well continue to be poor but because levels of market efficiency are low, moneymaking opportunities abound.

"The rate of scientific advancement appears greater than ever"

If you are not careful, emerging markets can be horrible places to invest. True, economic growth has been a lot higher than in developed markets, but that has not translated into higher returns for shareholders.

Far from it.

Since 1987, emerging markets have returned 7.4 per cent annually in US dollars compared with 7.7 per cent annually for US equities. Given the higher economic growth as well as the higher market volatility (23 per cent versus 14 per cent), this is not very impressive.

So, what is it that drives the performance of emerging markets as a whole? To put it simply, it’s global growth. When global growth is strong, as it was prior to 2007, or recovering, as it was in 2009 and 2010, emerging markets tend to perform well. This makes sense as emerging economies are seen as being geared to global economic growth. Further evidence of this is provided by the high degree of correlation between emerging markets and commodity prices.

There are two things going on here. First, commodity prices themselves reflect the strength of global growth. Second, many emerging economies are heavily dependent on commodities exports thus their terms of trade improve when commodities prices are rising. Of course commodities prices are a function of supply as well as demand, as we have seen all too clearly in the case of oil over the last 18 or so months, but the more important driver tends to be demand.

So, what is the outlook for global growth?

Opinion generally falls into one of two camps: those who think that growth globally is stagnating structurally and those who believe that the world economy will soon recover its former glory.

The pessimists, led by the likes of Robert Gordon and Larry Summers, believe that the combination of falling global population growth, high levels of debt and wealth inequality, and limited scope for productivity growth will cause growth to be materially lower than in decades past.

The optimists, on the other hand, believe that the lower growth we have witnessed in recent years is more cyclical than structural, driven by the slowdown in China as well as weak household and business confidence in the wake of the global financial crisis.

I find it remarkably difficult to decide which is correct, but on balance I side with the optimists. If anything, the rate of scientific advancement appears greater than ever, and I can’t help feeling that it will in coming years, whether in healthcare or energy or transportation, drive both the quality and quantity of growth.

As for declining population growth, I would imagine the world might well find ways to put unprecedented numbers of healthy retirees to work. After all, it has always been the nature of human enterprise to find solutions to problems.

That being said, I wouldn’t count on growth recovering anytime soon from the anaemic levels of recent years. Things just don’t tend to happen that quickly.

However, to do well out of emerging markets investing, you don’t need growth to recover to pre-crisis levels, you just need to be selective.

The emerging markets universe is littered with countries that are run by corrupt governments and companies that are badly managed. This largely explains why high economic growth has not filtered down to shareholders – it either gets pilfered or ends up in the hands of stakeholders other than shareholders.

A good example of a subsector of the emerging markets universe that has performed well over the years is listed affiliates of global multinationals, examples being Unilever Indonesia and Castrol India. In a 2012 paper titled “Emerging Market Outperformance: Public‐traded Affiliates of Multinational Corporations,” author professor Martijn Cremers identified 92 such companies across Latin America, Eastern Europe, Africa and emerging Asia and found that they substantially outperformed broader markets from 1998 to 2011 (2,229 per cent versus 1,157 per cent for the underlying countries and 371 per cent for emerging markets as a whole).

Cremers concluded that the reason for the strong performance lay in the strong management practices that filtered down from the parent entity. Shampoo and motor oil may not be exciting products but when put in a high growth economy and wrap them in a well-managed business, decent shareholder returns can result.

Since inception in March 2010, our favoured emerging markets fund has returned 22.2 per cent in sterling terms. Over the same period, the MSCI Emerging Markets index has fallen 8.3 per cent. In what is generally an inefficient asset class, if you pick the right fund, it doesn’t matter so much what markets are doing.

Published in Investment Week

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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