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Fund Strategy - 30 Jul 2012 | By Rodrigo Amaral

Emerging markets have furnished a beacon of hope for global investors since the global financial crisis started in 2008. But now even the pocket of resistance against sluggishness represented by the likes of China, Indonesia and Brazil seems to have got stuck in mediocrity.

Several economies that not long ago appeared to have no limit to their pace of growth have released data that has considerably disappointed markets. This is bad news for all concerned. If the global economy is to perform like Bradley Wiggins, emerging markets need to play the supporting roles of the other aces in the Sky team. But it suddenly looks as though Chris Froome and Mark Cavendish have been replaced by the likes of Del Boy Trotter, Jim Royle and Mr Bean.

Investors certainly seem to have reason to feel despondent. The International Monetary Fund and other institutions have reduced growth forecasts for emerging markets in general in recent weeks, damaging hopes that these markets could compensate for the dismal performance of developed countries. More threateningly in the eyes of free market enthusiasts, governments in countries such as China, Turkey, and Brazil have frantically intervened in their economies as they try to boost growth at any cost. Indonesia, an undisputed darling of markets a few months ago, is adopting policies that have raised many eyebrows. For some, such developments show that the enthusiasm investors have manifested for emerging economies may have been overplayed.

For instance, Victor Verberk, the head of investment grade credits at Robeco, says the idea much vaunted in recent years that emerging markets have decoupled from the weaknesses of the developing world does not stand scrutiny. He warned in an investment note that emerging markets are not “the safe haven that some investors think they are”.

Examples of this turnaround can be found everywhere. The World Bank has revised its 2012 growth forecast for South Africa from 3.1 per cent to 2.5 per cent, citing the effects of the weakening global outlook on consumer and business confidence in the country. Similar reasoning is behind the European Bank for Reconstruction and Development’s move in to revising downwards its perspectives for North African, Central European and Eastern European economies, including Russia.

Consultancy Ernst & Young expects Argentina’s GDP to grow a mere 3.3 per cent this year, compared with the 9 per cent it posted in 2011.

Neighbouring Brazil is struggling to keep its economy growing by more than 2.5 per cent as a credit-fuelled consumer boom seems to have run out of steam. The Indian economy has been marred by governance issues, and even China has lost some of its shine, posting disappointing GDP growth numbers in the first half of the year.

“Emerging markets have entered into this period in a much better position than the developed world”

Of course disappointing growth in China means an annual rate of 7.6 per cent in the second quarter, the kind of numbers that can only be dreamed about in the richer corners of the planet. Which shows that fears are sometimes excessive. As a matter of fact, emerging markets may be failing to meet the sanguine expectations of many investors, but they remain the main hope for the world economy to recover. In its latest evaluation of the global economic outlook, the IMF has reduced the expectation for emerging and developing markets growth to 5.6 per cent in 2012 and 5.9 per cent next year, 0.1 per cent and 0.2 per cent down respectively from its previous forecast. Not the stuff of economic booms, possibly, but still far from mediocre numbers. And experienced emerging market hands remain confident that the present malaise is not going to last.

“It has been kind of a blip, really,” says Jerome Booth, the head of research at the Ashmore Group. “The consensus is that emerging markets will resume solid growth soon.”

The main reason why the IMF has cut its forecast is the impact that the eurozone crisis and the weak external environment are having on emerging markets. To the direct economic effects, reflected in lower export revenues that have caused considerable distress, for example, in Eastern Europe, the fund added that higher risk aversion fuelled by financial uncertainty has driven capital flows out of some emerging economies. “

“The eurozone crisis is a major reason behind the slowdown,” says Nicolas Field, the deputy head of global emerging markets at Schroders. “It is hanging over the world like a big unknown and will depress incentives to invest until it is resolved.”

 

But he and other analysts note that in many emerging markets a slowdown often has more to do with their domestic economic cycle than with contamination from the European malaise. In the largest markets, such as China, India and Brazil, the woes from abroad rather exacerbate the situation than cause it, they say.

“If a country is in a slower period and the euro crisis continues, it is more difficult for it to get out,” Field points out. In any case, according to Claudia Calich, the head of emerging markets at Invesco, their challenges are less daunting than those faced by Europe or the US today.

“Everybody is being affected by the current turmoil, but emerging markets have entered into this period in a much better position than the developed world,” she says.

The contrast has actually been clear for investors who are able to see beyond the current wave of pessimism. In fact, flows of capital to emerging markets are reported to have been recovering, as many investors seem to be reassessing their concepts of risk.

“Due to the European crisis, investors are fleeing economies like Spain and Italy, and some of them are heading towards emerging markets,” Calich says. On the other hand, someone once said that it is important not to waste a good crisis, and the current slowdown could have some salutary effects on countries that for some time appeared to be bordering on overheating.

Calich highlights the case of Brazil, which for years lived a credit bonanza that was starting to fuel concerns about bubbles. “Credit in Brazil was growing too fast, it might not have been sustainable,” she says. “So the current economic slowdown could have a positive side.”

Ernst & Young says slower rates of growth can help suppliers in emerging markets to adjust their production lines to demand that is not expanding as fast as it might otherwise be. Infrastructure investment, a must for more than one fast-growing country, also has more scope to catch up when the economy is not on fire. The consultancy adds that a less dynamic China can have a positive effect on commodity prices, taming the inflationary threat in other countries and reducing transport costs, as oil prices do not suffer as much pressure as when the Middle Kingdom is going at full throttle.

In a recent note, Merrill Lynch Wealth Management pointed out that global food prices are 8.4 per cent below the levels of one year ago, when inflation was a global concern, while energy prices are 13 per cent lower than in March.

But that does not mean that governments will take the risk of a slowdown lightly. Luckily, the fiscal and monetary positions of the most important emerging countries remain robust, especially compared to the state of government balance sheets in the eurozone. China has triggered another round of economic stimulus to fend off sluggishness, although not to the size of the giant package it implemented in 2009. It also cut interest rates in June, for the first time since 2008. Brazil and Turkey have been slashing their reference rates, even though they remain quite high, by global standards, in both countries.

More recently, South Africa has announced a cut in rates for the first time in 20 months, taking markets by surprise. This kind of action may well look refreshing for many observers, not the least if they are contrasted with the comings and goings of European and US leaders.

Take the case of China, where earlier this year the government started to relax, although moderately, conditions for the granting of credit, and new investment policies are being implemented after the economy slowed down for six consecutive quarters. To a considerable extent, these measures revert to the previous policy adopted by the Chinese government, which last year was more worried about taking the heat out of the economy and preventing the swelling of what appeared to be a dangerous property bubble.

The head of the IMF China team, Markus Rodlauer, notes that the eurozone crisis and the consequent global slowdown have actually made such policies work too well, containing the economy more than the government expected.

“The Chinese government is trying to be proactive, which is quite different from what the Western governments have done,” says Edwin Gonzales, a portfolio manager at Aberdeen Asset Management. “The slowdown in China is very much policy induced, so we are not that concerned about it.”

He is less sanguine, though, about policy measures in other emerging markets. In Indonesia, for example, the central bank has generated concerns among investors by implementing capital restrictions, while the government of president Susilo Bambang Yudhoyono has been playing with the idea of restricting foreign ownership in its vital mining industry.

“Indonesia has held very well, but we have concerns about policy,” González says. “Policy was very reformist during the president’s first term, but now the government seems to have lost the focus somewhat.”

 

Investors have lost some of their enthusiasm for the country, which earlier this year posted the fastest rate of growth in 15 years but whose equity markets have lagged their peers in Thailand or the Philippines so far this year. González does not consider, however, that the effects of such measures on the Indonesian economy will be disastrous, and Ernst & Young has forecast that the country’s fundamentals remain strong enough to justify a growth forecast of 6.1 per cent this year.

The jury is out, too, about the aggressive policies being deployed by Brazil, another emerging market that is central to the portfolio of many investors. The IMF has slashed this year’s growth forecast for the country from 3 per cent to 2.5 per cent, following a disappointing 2011, when growth was 2.7 per cent. Market analysts surveyed by the Brazilian central bank have even more lacklustre expectations. The Fund attributes the slowdown mostly to previous efforts by the government to contain inflation, compounded by the effects on the country of the global economic outlook.

The government has reacted by launching new taxpayer-funded investment programmes, while the central bank has cut interest rates at a pace never seen before. But analysts say Brazil relies too much on the role of the state to get it out of its slump, and it is doubtful that such a strategy will deliver the best results. “Some official institutions like BNDES [a huge development bank] can provide part of Brazil’s investments needs,” Calich says. “But if the country fails to attract more private capital, economic growth won’t be so strong.”

“Corporate debt in emerging markets is becoming a very large asset class, not only in dollars but in local currencies too”

Booth says: “Brazil has not been helped by a lack of sufficient investments in infrastructure. In fact, the portfolio inflows that could help that have been discouraged, which seems a bizarre policy. But growth will pick up again.”

The IMF also expects growth to resume with some vigour later this year, reaching 4.5 per cent in 2013. Calich says the country still has weapons to deploy, even if they could potentially foment other risks. “Brazil has room to cut interest rates further, although inflation is not below the central bank target,” she adds. “This is a paradox in an economy that is slowing, but where inflation remains above the target.”

Brazil has actually lost to Mexico some of its status as the Latin American market that everybody needs. Mexico has been of late an economic feelgood story that is often overlooked because of the country’s appalling record of drug violence.

“Mexico is our favourite country overall today,” González says. “They have been growing fast, despite the headwinds coming from the north.” He adds that the country has a very open economy with a potential to post annual rates of growth of 3.5 per cent to 4 per cent for a long time. In fact, the Mexican market has done well in recent months even though the performance of its key export market, the US, has proved disappointing.

“Mexico has been able to more than survive but even to thrive during the crisis,” Gonzáles notes. Exports are a huge factor, as companies based in the country have been able to regain market share in the US from Chinese competitors, and even from Canadian firms too, he says.

India faces very different circumstances. It has one of the most closed economies in the world and has met some hurdles to fast development recently. In March, the annual rate of GDP growth reached 6.5 per cent, which was well below expectations and fuelled calls for a cut in interest rates. But inflation in June was 7.25 per cent, which, although lower than in May, is an uncomfortable level for any central banker.

 

So the central bank has stayed mum for the time being. Some analysts believe the Reserve Bank of India is restricting monetary action in an effort to force the the government to put its finances in order and boost investment in the economy, which could be a problem of its own.

Field says:“High levels of Indian growth have been dependent on infrastructure investments, particularly in the power sector, where they need a rapid improvement. As the government has become mired in corruption cases recently, mainly in the power sector but in other areas too, investments have come to a halt.”

Field is concerned that, even though emerging markets have been eager to react to economic malaise, they may have less room to manoeuvre today than back in 2009, when decisive action was taken everywhere to dispel the effects of the Lehman Brothers collapse.

“Interest rates have not recovered to the levels they were back then,” he says. In any case, even though rate cuts are generally an efficient way to give the economy an immediate shot in the arm, their limits have been made evident by the US and Europe in recent years. And Field is also worried that ever lower rates could lead some emerging markets into the same kind of liquidity trap that developed economies are struggling with today.

“Interest rate cuts could have a limited effect if the external scenario does not improve,” he says. “The situation is quite challenging today, and emerging markets can make mistakes too.”

And even if they are more likely than the rich world to deliver growth, emerging markets still have a lot of work to do to guarantee the soundness of their economies in the long run.

The IMF has noted for instance that China needs to promote a significant change of tack, promoting domestic consumption as an alternative to the investment-driven, export-led economic model of today. India is criticised for not doing enough to open up its borders to foreign investors, while the role played by the state in countries such as Russia is considered excessive. In Brazil, reforms in areas such as labour law, tax and pensions are seen as sorely needed, while the urgent update of its dismal infrastructure continues to be delayed, hampering the perspectives of accelerated growth.

All things considered, however, it is hard to argue against the view that if investors are looking for growth they are likely to find it in an emerging economy, and that is a situation that is unlikely to change for some time.

“The emerging world will still suffer from economic cycles, but not the sort of balance sheet recession that the developed markets are going through right now,” says Field. And the present slowdown could even create investment opportunities for investors who have not surrendered to risk aversion.

“Equities in emerging markets look extraordinarily cheap today,” says Booth, who adds that they have the extra attraction of creating exposure in local currencies that are likely to gain value against the dollar or the euro.

But other alternatives are available, too, for those investors concerned about the future of developed world currencies. Booth says, for example, that short-dated government securities in emerging markets surplus currencies look like some of the safest assets in the market today.

“Particularly if you fear the worst-case scenarios in the United States and Europe, this is the right place to be,” he says. In Booth’s opinion, dollar-denominated sovereign debt issued by emerging market governments can also be a very attractive high-yield alternative to US treasuries and German bunds. And corporate bond markets, which are thriving in several emerging markets, have plenty to offer as well.

“Corporate debt in emerging markets is becoming a very large asset class, not only in dollars, but in local currencies too,” he says. “They offer alternatives for diversification not only in several countries, but also in different segments of the economy.”

Long-term investors may have even more reasons to look at emerging markets. The fast-growing affluence of Asian consumers is enough to make many a company – and its shareholders – salivate.

Ernst & Young expects emerging Asian economies to account for 25 per cent of the world’s consumer spending by 2020, and 40 per cent 10 by 2040, compared with 14 per cent in 2011. By 2020, emerging markets as a whole should have 149m households with an income of more than U$30,000 a year, which will be more than in the US or in the eurozone.

All in all, a new global economy is emerging, a trend that the present woes of rich nations tend only to make more evident. Emerging markets may still meet a few bumps on the road, but there is little doubt that for a long time to come they are where the action will be.

“Every time we have this kind of shock from the United States and Europe, emerging markets become more resistant,” Booth says. “And the shocks now seem to come every year.”

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