3 reasons emerging markets could outperform

Emerging markets will become more attractive over the long run, according to Éric Morin, senior analyst at CIBC Asset Management, as macroeconomic factors improve living standards and make emerging economies less risky.

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“The drag on economic growth will be much smaller in emerging economies than in most advanced economies because policy rates of central banks are less below their respective long-run neutral rate,” said Morin in an interview earlier this month.

“For central bankers in developed economies, where rates are extremely low, higher policy rates will be needed to cope with potential future economic downturns, and to prevent further build-up in financial imbalances associated with too-low-for-too-long interest rates,” he said.

“The bottom line is that policy renormalization of central banks will hurt emerging economies [less] because rates are much less below the neutral policy rate.”

As a result, emerging markets will have better long-term profit growth, he said. Here are three more reasons he likes emerging markets.

• Smaller debt loads

Emerging economies have smaller debt loads as a share of GDP, said Morin. This means “smaller debt servicing for consumers and governments following [an] increase [in] interest rates.”

• Economic growth

Living standards in emerging economies are catching up with those in advanced economies, which leads to accelerated growth, said Morin.

“For example, more than a century ago, living standards in North America were still moving towards those of the U.K. and Western Europe. This process of convergence resulted in superior economic growth in North America,” he said.

Meanwhile, the process of convergence of living standards has gathered momentum in emerging economies in the last decade.

“Now, GDP per capita in developing and emerging economies accounts for about 40% that of advanced economies,” he said—twice as much as a decade ago.

A more diversified economy has contributed to the growth, he explained.

“Like a financial asset portfolio, the more diversification you have, the less idiosyncratic risk you take. As a whole, emerging economies have made considerable progress in transitioning away from excessive reliance on exports and commodities. Reflecting this, the tertiary sector dominates the equity market with a share of about 70%, similar to developed markets.”

Further, a more diversified growth mix paves the way for sustainable, long-term “macroeconomic performance, and provides better resilience against negative macroeconomic shocks, such as increasing interest rates,” said Morin.

• The Phillips Curve

The Phillips Curve is the inverse relationship between inflation and unemployment. In the past, he said, the sensitivity of inflation to labour markets was higher when labour markets were tight.

“The consequence was that the Fed had to tighten its monetary policy […] which resulted in important capital outflows outside emerging market economies,” Morin said. “This relationship between inflation and labour markets has weakened considerably over time, meaning that the Fed is less likely to aggressively tighten [its] monetary policy. [So] emerging market economies are less at risk of experiencing an outflow of capital following an aggressive tightening path by the Fed.”

Country breakdown

While there are positive macroeconomic factors for emerging economies as a whole, there are significant divergences between countries.

For instance, Argentina and Turkey are still vulnerable to economic shocks, he said.

Meanwhile, South Korea can “now be considered more developed than some of the smaller developed countries, such as Portugal. There’s been a rapid convergence of living standards in South Korea.”

Two decades ago, GDP per capita in South Korea was about 25% below Portugal’s, he said. But now the GDP per capita in South Korea is about 30% larger than Portugal’s.

“What has been going on in South Korea is more than growth catch-up. South Korea has simply outpaced many advanced economies by becoming better and more competitive at producing high value-added goods.”

Many emerging market countries are slowly becoming advanced economies, he said.

“From a macroeconomic perspective, many of them are in their sweet spot,” said Morin. “Economic growth [is] outpacing that of developed economies because of the catch-up of living standards. They have become less risky over time. This has contributed to [making] several emerging markets more attractive from a risk-return perspective.”

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