Economic lessons from emerging markets

To listen to his critics, U.S. Federal Reserve chairman Ben Bernanke hasn’t gotten a lot of things right. His recent thoughts on emerging markets, though, seem consistent with what empirical evidence bears out.

This past Wednesday he told a forum in Cleveland, Ohio, that developed economies like the U.S. “would do well to relearn some of the lessons from the experiences of the emerging market economies.”

The moral of the emerging market growth story, he said, is that it pays, in spades, to support disciplined fiscal policies, open trade, and private capital formation while undertaking necessary public investments. Put differently, the current economic climate has not been caused so much by bad weather as by inappropriate clothing.

Emerging market pundits have been tireless in projecting how these economies have recalibrated to be at the forefront of global economic change.

EMs leading from the front

The International Monetary Fund (IMF) forecast indicates emerging markets will grow at a rate 4% higher than developed markets in 2012, and this trend is likely to continue for many years to come, says Pallav Sinha, chief executive and president, Fullerton Securities and Wealth Advisors, a wealth management firm in New Delhi, India.

“It is inevitable that emerging markets, which constitute less than 30% of global market capitalization, will have an increased share of close to 45% by 2013-14,” said Sinha. “This would be the inflection point at which emerging markets as a whole will overtake the developed world in global GDP share with 51% of GDP coming from emerging markets.”

While he admits that eventually the pace of growth in emerging economies will slow—high growth economies such as China, India and Brazil will face moderation in growth as the early stage benefits of improved productivity start diminishing with increased economic maturity—he asserts they will outperform developed markets significantly.

“Juxtapose this with the fact that emerging markets still contribute less than 30% of the global market capitalization, and the case for sustained outperformance by emerging markets is evident,” said Sinha.

Like many other emerging markets, the growth of Latin America stands in contrast to the OECD countries, says Scott Piper, portfolio manager with Brazil-based Itau Asset Management, portfolio sub-advisor to the Excel Latin America Fund.

The region, historically an overleveraged collection of countries, is now actually the opposite. “If you look at Latin America as a region, it’s highly underleveraged relative to the developed world, sovereign debt is extremely low, and the banking system, which is to some degree the Achilles’ heel [of the economies like] the U.S. and Europe, is quite sound in Latin America,” said Piper.

When the dust settles and the ongoing market volatility subsides, the world would be looking at a region far less risky than the developed world, predicts Piper.

He points to some “very positive secular tailwinds” for growth in the region including rising employment, a young population, a growing middle class and rising consumption. In Brazil, for example, the middle class is estimated to grow by 60 million people by 2014, he added.

Demographics, the rising middle class and consumption are the main drivers of growth throughout the emerging world. “Domestic consumption is a very powerful, multi-year growth trend in Latin America that is being supported by all of these positive dynamics,” said Piper. “In addition to that, infrastructure and investment—related spending are also strong pillars of growth.”

Valuations

Brazil has something else going for it. The country is due to host the 2014 FIFA World Cup and the 2016 Summer Olympics. Events of such scale are always a catalyst for infrastructure spending.

“Those are relevant advantages being overshadowed by the recent market volatility which has pushed the valuations for the region,” said Piper. But despite being highly distressed, these valuations are very attractive relative to the growth opportunity which is coming at less risk than in the developed world, he added.

Sinha provides some more encouraging data around valuation in emerging markets. “The emerging markets index, MSCI GEMS has corrected steeply by 9.2% in August and a further 7.8% this month. MSCI GEMS now trades at 8.4x for one year forward earnings, a 26% discount to its historical average of 11.4x.”

This makes valuations of emerging markets quite attractive for an investor with a medium to long-term horizon.

Detractors of emerging markets argue that global uncertainty causes a state of panic across all asset classes and even un-correlated asset classes reflect higher correlation, or in other words, reduced benefit of diversification.

Sinha says this is an aberration rather than a long-term trend. The occasional correlation between typically inversely-correlated asset classes, known as “black swan” events, do not announce the arrival of a “new normal,” he added.

“Emerging market equities will continue to offer diversification to long-term investors based on different GDP growth rates, interest rate cycles, currency etc.”

Inflation

Inflation in India and China and some other emerging economies has continued to surprise on the upside. Sinha admits this is an issue of concern for global investors, but believes that softening of commodity prices by the end of this year or early next year could have a salutary effect on inflation.

“At this point of time, the risk of inflation is not as much about an increasing rate of inflation, but about persistent and structural inflation,” said Sinha. “Investors do need to be wary of such a risk as it could imply lower growth than is being currently projected for emerging markets.”

Things are no different in Brazil when it comes to inflation, according to Piper.

“Inflation has actually been rising in Brazil over the last year and a half on the back of the fact that the economy has been so strong and as a result interest rates have been rising right along with it,” he said. “That’s one of the reasons we saw outflows from Brazil and other parts of the region in early part of the year as people were concerned about the ongoing tightening cycle.”

That monetary tightening cycle, he said, has now ended. Inflation peaked in Brazil in August at about 7% and is expected to fall to about 5% in the first quarter of 2012.

Piper points to another distinction which is “a lot of policy flexibility in the region versus the developed world.” In other words, interest rates are still high enough that they can be reduced as global headwinds come from the developed world.

Emerging markets can also expand fiscal policy to support growth, said Piper. “Policy flexibility or running a counter-cyclical policies framework is just not something that the developed world has at the moment; that ammunition has already been spent.”

Bernanke’s point exactly.