Doug Helget : Northwestern Mutual - Economic Commentary - April 2010 : Article: Economic Commentary

Economic Commentary - April 2010

Christopher Bremer

Senior Investment Consultant

A Journey through Emerging Markets

Thirteenth century Venice is renowned for its prosperity, merchants, sailors and ships. Venetians regarded the world as globally connected across boundaries and geography. Merchants viewed the world as a network of endless trade routes and business opportunity.[1] The most celebrated Venetian merchant and global traveler, Marco Polo, spent 24 years traversing the Asian continent and became a trusted diplomat for the Mongolian empire.

Marco Polo’s accounts of his travels were initially interpreted as entertainment and fabrication. But his accounts were more than just conjecture; in fact, Marco Polo represented a bridge between two vastly different civilizations and he was perhaps the only one of his time to possess a deep understanding of both worlds. Exploration was not his objective. He understood that commerce had the potential to conquer conflicting political and religious systems.

Today, a different kind of commerce is conquering strategic asset allocation and portfolio management. Emerging market investments are widely regarded as a global growth story, a bridge between the debt laden budgets of the major advanced economies and, particularly to investors residing in those countries, the investment opportunities presented by future global gross domestic product (GDP) output.

The origin of the term “emerging markets” is generally dated back to 1981 and an investor, Antoine van Agtmael, who was trying to start an equity fund: “Racking my brain, at last I came up with a term that sounded more positive and invigorating: emerging markets. ‘Third world’ suggested stagnation; ‘emerging markets’ suggested progress, uplift and dynamism.”[2] As the new term took hold, it referenced levels of wealth in economies with lower per capita income.

More recently, the optimism over emerging markets’ potential can be traced to a Goldman Sachs report that championed the BRICs (Brazil, Russia, India and China).[3] The theme of the paper is that the BRICs will be a much larger force in the world economy over the next few decades.

As far as the case for emerging markets goes, the global economic crisis of 2007 to 2009 represented a significant departure from historical norms. Typically, emerging market dislocations have occurred during stock market bubbles and crashes as well as during financial crises, crises that historically have originated within emerging economies. This time, however, the financial crisis originated in the largest, most developed

economies in the world. According to the International Monetary Fund (IMF), reflecting improved policy frameworks, emerging economies have withstood the financial turmoil considerably better than expected based on past experience.[4] Infrastructure spending, exports and less overstretched housing markets’ government debt burdens helped emerging economies manage through the global crisis better than their developed counterparts (Fig 1).

As an economic commentary, we are not so much concerned with the investment case for emerging markets as we are the drivers of current and expected emerging market growth. In the following, we discuss the potential for faster economic growth and three factors supporting this growth; fiscal structure, productivity and attractive demographics.

Faster Economic Growth

Economic activity involves not only interaction between consumers, business and government, but also interaction between and among global entities and individuals. When the term was coined in 1981, emerging markets’ contribution to world output was marginal at best. Today, business and financial interactions both among emerging and developed economies and between emerging economies are driving global GDP growth. According to a Northwestern Mutual study, developed economies account for 74% of global GDP, but emerging economies account for 58% of global GDP growth. According to the World Bank, the share of international trade in emerging economies has grown from 35% in 1980 to 57% in 2007.

The International Monetary Fund Data Maps (Fig 2-3) show Real Gross domestic product (GDP) growth in 2009 and a GDP projection up to 2014. According to the IMF, GDP is the most commonly used single measure of a country’s overall economic activity. It represents the total value at constant prices of final goods and services produced within a country during a specified time period, such as one year. Note the stark differences between the maps for 2009 and 2014. Green represents lower growth, while shades of red represent higher growth.

As 2009 came to a close, GDP growth had already climbed back to positive territory for most emerging market economies. There are significant differences regionally, with Asia generating the most growth currently and some eastern European countries still with negative growth. Industrial production, global trade and consumer activity all contributed to the rebound in growth (Fig 4).

Upward revisions for global growth are being driven by more optimistic forecasts for demand

among consumers and producers, led by China and India. Just as the current global recession demolished the emerging markets “decoupling” theory, a quicker and more robust upturn within emerging economies may signal better prospects ahead for developing nations, albeit at a more moderate pace.

China and India

The global financial crisis of 2008-2009 caused significant economic slowdown in China, although the Chinese economy never actually contracted. The Chinese economy continues to lead global growth with few signs of slowdown looming.

Production and retail sales are expanding more than 20% and imports are up considerably, providing a boost to global exporters. At the same time, China’s largest cities are being built on aggressive lending, which has the potential to lead to inflated prices and overextended investors. Concerned about overheating in lending and real estate, Chinese policymakers, as we discussed last month, have begun implementing measures to reign in aggressive bank lending.

India has averaged GDP growth of 7.1 percent over the decade through the third quarter of 2009, compared with 9.1 percent in China. India is on a quest to become the world’s fastest growing economy within four years. Any reader who owned risk assets from 2003 to 2009 is probably reading that statement with much skepticism. What policies are driving growth? How will stimulus be withdraw in a way that supports such high growth rates? What areas are at risk of becoming a bubble? How is India connected with other major economies?

Fiscal Structure

The extraordinary amount of policy stimulus has been driving the global economic rebound off the 2009 doldrums. Monetary policy has been expansionary, with interest rates at record low levels across all economies. Many emerging market countries implemented fiscal and monetary stimulus with more swiftness and with more effect than the U.S. and Eurozone countries.

A key factor in the flexibility of emerging markets to implement fiscal and monetary stimulus has been the less restrictive amounts of debt (Fig 5). Historically, crises in emerging economies have been ignited or fueled by excessive levels of government or private sector debt, or both. Debt burdens throughout this recent crisis, however, have been lower than in the past. In fact, some emerging economies are net lenders to the global financial system. Entering the financial crisis in 2007, the developing economies were holding debt levels at 25% of GDP, the lowest levels since the early 1980s.[5] While not immune to the global financial shocks, lower debt burdens limited the damage that may have otherwise occurred.

Emerging market central banks are likely to lead the global monetary normalization. Brazil is expected to raise interest rates in April. India already has. By entering the crisis in relatively strong financial condition, with reserves and fiscal policy flexibility, and previous crisis experience, many emerging economies declined at a more moderate pace than some of the more advanced economies.

Productivity

Productivity growth leads to sustainable economic growth, which leads to a higher standard of living. For global-oriented companies, higher standards of living represent an alluring consumer base. As the demographics of most global economies turn progressively older, countries will have to rely on productivity gains to compensate from the working age shortfall.

Recently, there have been wide gaps between productivity per worker hour in the U.S. and Europe. U.S. companies were far more aggressive in slashing jobs and managed to squeeze out high productivity from those fortunate enough to keep their jobs.

Productivity in advanced economies has tapered off and trended lower since the 1990s. Global production, as measured by increases in output per working person, turned negative in 2009, the worst year on record since the early 1980s.[6] While the U.S. and Europe may experience little or no employment growth this year, many emerging economies will benefit from both production and employment growth, a powerful combination toward relative global output. On average, productivity growth in the seven largest emerging economies was 3.6% in 2009, down from 5.3% in 2008.[7]

Figure 6 clearly shows the decline in productivity in the U.S., Japan and Eurozone from 1995 through 2009. Of note, Japan and the Eurozone increased productivity on average less than one percent in the five year period through 2009. Output per worker in the major emerging economies, conversely, grew at an average rate of 5.9%, with China pulling the average higher.

Attractive Demographics

Attractive demographics lead to larger consumer market opportunities. Economic strength in countries with mass middle consumer market potential are attracting foreign company investment.

The emergence of a global consumer class in many developing nations has had a profound impact on global growth prospects and the allocation of resources. Following are just a few metrics of the many drivers of demographic influence:

· Using the range of the average incomes of Brazil and Italy ($12 to $50 per day), the middle class population of emerging markets was about 250 million in 2000, 400 million in 2005 and according to the World Bank, will be 1.2 billion in 2030.[8]

· In China, the number of people living on $2-$13 per day rose from 174 million to 806 million in 15 years.

· According to the National Council for Applied Economic Research, the middle class accounted for 5% of the population in 2005. By 2015, the middle class will account for 20% of the population and over 40% by 2025.[9]

· Today, according to the United Nations, 82% of the world’s population lives in “developing regions.” This share is expected to rise to 86% by 2050.

As a base case scenario, growing populations mean larger opportunities for producers of goods and services. While population growth rates have been in steady decline since early 1980s, relative population growth still favors the developing world. According to Citigroup, in 2007 the annual emerging market population growth rate was 1.4% vs. 0.3% for the developed world.[10]

The United Nations defines the “old-age support ratio” as the number of persons aged 15 to 64 years per person aged 65 or over. As Figure 7 shows, the ratio declines materially for all regions of the world between 2009 and 2050. While the pace of decline actually accelerates more for the less developed regions, the relative population growth is compounded by the higher relative number of workers per person over 64 years of age. The net result will be that a greater proportion of the world’s working population will reside in emerging economies over the coming decades.

What to Watch for

Inflation is widely regarded as a key risk for emerging markets in the near term. Many emerging markets’ economies are linked to commodity prices, and commodity prices tend to precede inflationary pressures (Fig 8).

Because emerging economies weathered the financial crisis better than the advanced economies and because emerging economies are returning to growth sooner, stimulus withdrawals will occur in these countries first (Fig 9). On March 19, the Reserve Bank of India raised its benchmark reserve repurchase rate to 3.5 percent from a record-low 3.25 percent, saying, according to Bloomberg, that containing inflation has become “imperative.” It is noteworthy that this action came one month before its scheduled monetary policy meeting. In Brazil, economic observers raised the prospects of Brazil raising interest rates any time. Brazil’s economy expanded 2 percent in the last quarter of 2009 and retail sales increased significantly.

Where are we headed?

In the current environment, the term “emerging markets” is synonymous with growth and investment potential. The decoupling theme rose to prominence prior to the global financial crisis of 2007 to 2009. This theme argued that emerging economies could grow independently of the developed world. While these economies may, in fact, succeed in generating stronger relative growth, the recent recession demonstrated that no country or region is immune from severe global financial shocks.

As market participants and strategists have developed more optimistic outlooks for continued global recovery, focus shifts to sustainability in the aftermath of pending stimulus withdrawal.

In this commentary we have discussed the economic case for emerging markets. Financial and industrial considerations also play important roles in evaluating the emerging market economic and the investment rationale. Extending from and beyond the growth case, many proponents of emerging markets cite underpenetrated consumer markets, massive infrastructure demands and improving economic regimes as supportive of the investment case.

Because emerging economies are directly linked to fixed income and equity market portfolio allocation opportunities, a brief discussion is warranted. Emerging markets tend to be fundamentally riskier and have historically demonstrated wider variations in return patterns,

or volatility. Because of these differences in risk characteristics, many financial institutions consider emerging markets a distinct asset class. As a proportion of broad U.S. and international index market capitalizations, emerging markets have been gaining significant market share over the past decade (Fig 10).

There have been numerous studies and debates on the diversification benefits and correlation (the degree to which asset prices move in tandem) between U.S. domestic and emerging market equity returns. Drawing conclusions is beyond the scope of this economic commentary, as is making an investment recommendation. But trends clearly indicate that correlations between emerging markets and U.S. equities have increased over time.

From the perspective of portfolio theory, however, it is not a stretch to believe that growing economies may potentially lead to higher revenues for global-oriented companies. Over long periods of time there is a general, but certainly imperfect, linkage between economic growth and equity returns. Attempting to link shorter-term growth horizons to predictions on market returns, however, is futile at best and destructive to portfolios at worst. Intuitively, favorable economic growth trends should provide a supportive environment for equities.

Supportive conditions can and do turn into inflated asset prices; price and entry point, like any other investment, are critical to investment outcomes. We consistently caution against “this time is different” stories, and investors should keep a watchful eye on justifications for new and different emerging market themes. Economic sensibility is imperative. Any investment consideration in emerging markets, or any thematic opportunity for that matter, should provide a clear and objective benchmark against which to measure progress toward objectives. Investors need to recognize that there have been periods of time where emerging markets have reduced portfolio returns while at the same time increased overall volatility, the worst case scenario for investors seeking better “risk adjusted returns.”

In trying to assess the viability of emerging market economies or markets, two shortcomings persist relative to assessments of developed economies. First, the history of emerging economic data is short relative to U.S. economic and stock market data. Second, economic, social and political changes are far more unpredictable and limit the interpretation of the limited data set. It is virtually impossible to forecast economic or market directions - or even winners and losers - among emerging economies.

Forecasting faster economic growth among clusters of less developed economies, however, is feasible and where there is growth, there are opportunities. Opportunities entered into at the wrong price, however, often result in losses. Given the magnitude of the economic and equity market recoveries, the scope for upside surprises as well as the tolerance for disappointments narrows significantly. Heightened volatility will still be prevalent within and among emerging economic data, fixed income markets and equity prices.

Emerging market risks remain numerous and are very real. Political risk, economic policies, regulatory environment or lack thereof, investment limitations, and industry concentration are just a few. And these represent only the macro risks. Google’s recent retreat from China provides a real reminder of the difficulties multi-national firms face in conducting business in more restrictive environments. Google’s actions follows a recent American Chamber of Commerce report indicating that some U.S. businesses are losing Chinese sales because of rules to support home-grown technology.

Eight percent annualized GDP growth for emerging economies may not be sustainable over the long term but that does not mean short-term setbacks will mean the growth story is exhausted. Throughout his travels, Marco Polo’s perception of distance was subjective; commerce and diplomacy guided his direction, not cartography. Distance was measured by “day’s journey.”[11] Likewise, we encourage investors to measure emerging markets’ progress or investment allocations by a longer-term measure of distance - in years, not weeks or months.

[1]Marco Polo: From Venice to Xanadu, Laurence Bergreen, published by Alfred A. Knopf, 2007.

[2]The Economist, “Ins and outs; Acronyms BRIC out all over,” September 18, 2008.

[3] “ Dreaming With the BRICs: The Path to 2050,” Dominic Wilson and Roopa Purushothaman, Global Economics Paper No:99, Goldman Sachs Global Economics, October 2003.

[4]“World Economic Outlook: Sustaining the Recovery,” International Monetary Fund, October 2009.

[5]Citigroup Global Markets, “Special Report: CEEMEA for the Long Run,” September 24, 2009.

[6] The Conference Board, “The 2010 Productivity Brief: Productivity, Employment, and Growth in the World’s

Economies,” by Bart van Ark, Vivian Chen, Abhay Gupta, Gad Levanon, and Andre Therrien, No. 319, January 2010.

[7]Ibid.

[8] The Economist, “Burgeoning Bourgeoisie; A Special Report on the New Middle Classes in

Emerging Markets,” February 14, 2009.

[9]Ibid.

[10]Citigroup Global Markets, “Special Report: CEEMEA for the Long Run,” September 24, 2009.

[11]Bergreen, et al.