When the German chancellor Angela Merkel visited Beijing in late August 2012, a new and strange dynamic in world affairs was in full view. In London, Frankfurt and New York, markets waited anxiously to hear not what Merkel might say about China, but what her counterparts would say about Europe.
The Chinese premier Wen Jiabao (pictured below with Angela Merkel) offered some comfort, suggesting that his country, still flush with cash, was prepared to buy some European sovereign debt, but warned that the People’s Republic would not provide an unconditional backstop for the single currency area. The tone was chastening.
This episode stands as evidence that the centres of growth and economic power in the world have changed, and changed structurally. The centrality of China to the world economy was cemented throughout the early stages of the financial crisis, as recessions in the developed world were counterbalanced by growth in much of Asia. Parts of Latin America, Africa and the Middle East too continued to grow, unburdened in the most part by the crippling public and private sector debts that had become so toxic in Europe and North America.
At the start of the financial crisis, emerging markets accounted for just over 50% of global gross domestic product as measured by purchasing power parity; more than 50% of the consumption of major commodities, including 75% of steel; nearly 80% of foreign exchange reserves; and more than 80% of the world population. Statistics are hard to come by in later years, but the majority of analysts reckon that most of the big economic performance figures have moved in favour of emerging markets after 2008.
This changing centre of gravity has been manifest across a number of spheres, from the growth of genuine corporate giants in the emerging world – which now make up 25% of the Fortune Global 500, the biggest companies in the world measured by revenues – to the visible shift in geopolitical power, and hence global economic policymaking, from the Group of Seven to the Group of 20, which began before the financial crisis but was cemented by it.
The performance of emerging market assets, particularly equities, has been vulnerable to shifts in sentiment across the decade, and investors’ appetite has waxed and waned. In the early 2000s, after the explosion of the dotcom bubble, there was a rush to invest in the compelling growth stories in areas of the world whose post-Cold War emergence as market economies was by then well established.
Goldman Sachs economist Jim O’Neill (pictured left), in coining the term “Bric” to bring together the four leading emerging markets – Brazil, Russia, India and China – created an easy shorthand and accessible theme for investors. In the case of the latter, it was potent demographics, huge inflows of foreign direct investment and the creation of large, export-driven industrial or offshoring bases that provided the growth engine. In the former, it was for the most part commodities and liberalisation in core industries.
While the financial crisis of 2008 and the sovereign debt issues that continue to paralyse Europe seemed to reinforce the thesis that the global economic balance had shifted permanently, there has also been a big dumping of emerging market investments. An international tightening of liquidity saw many abandon the previously high-performing markets as they retrenched to cover positions back home. For all of the long-term strategy that had been discussed prior to the crisis, the short-term imperative won out.
“There was a flight to quality and flight to liquidity,” Ronnie Armist, executive director at British multi family office Stonehage, recalls. “However, they bounced quite nicely. There was a huge stimulus in China. We saw that the commodities picked up in anticipation of a Chinese economic boom and we saw after the credit crunch that emerging markets had another day in the sun.”
But that recovery remained vulnerable. After two years of risk- on, risk-off trading driven by post-quantitative easing liquidity, political drama in Europe and dramatic political change in formerly promising markets in the Middle East, emerging markets have started to dip once again. Key to this is China, whose attempt to stimulate domestic demand to counterbalance falling external demand was only a qualified success. Commodity prices have fallen back as a result, with a knock-on effect on other developing countries that depend on them for revenue.
“With commodities having come off the boil and China slowing down, at this stage, emerging markets have not been great performers,” Armist says. Dan Briggs, chief investment officer at the UK’s Fleming Family & Partners, acknowledges that the shift towards emerging markets is “an inexorable secular trend”, but says that the investment house has tempered its enthusiasm in recent months as valuations of publicly traded assets have started to catch up with their developed market peers.
“There was a real differentiation in the speed of growth in different areas. That really mirrored what had happened before the crisis,” Briggs says. “But I think what’s happened is that we’ve seen one or two of the Brics countries, such as Brazil, slow down very markedly, and it’s not just about resources, it’s about domestic demand and it’s about confidence.” The past few years have put paid to the notion of decoupling, which was popular among some who were marketing emerging and frontier funds in the early days of the financial crisis.
“We’ve kind of acknowledged that the world is more connected,” says Briggs. “There was always the sense that if America stuttered, then you would have a very serious flu in emerging markets and I think probably we’ve gone back to that situation. It’s cast a very serious shadow over emerging markets.”
Simon Hopkins, chief executive of Milltrust International, a Singapore-based investment advisory group specialising in emerging markets, encapsulates the problem for investors, who have to balance the long term. “I think the issue really is that the world has changed post 2008, in my view. We are now in a prolonged period of very slow growth, if not recession, in the western world. The fiscal problems that unfortunately challenge the western world governments in America and western Europe will persist for the next decade ... What people are waking up to in that context is that 50% of global GDP now comes from the developing world, but the markets have been disappointing.”
This slowdown, with its epicentre in Europe, is also changing the way we look at the world economy. With the fallout from the financial crisis having dire consequences for much of southern Europe, some commentators say the phrase emerging markets is looking increasingly irrelevant and dated. Hedge fund manager Jonathan Binder says investors should look at the world in terms of countries that are fiscally responsible and countries that are not. And new terms are being used to describe fast-growing economies in the developing world like frontier markets, the Next 11 and Civets (see definitions). But emerging markets is still the catch-all phrase preferred by investors to describe non-developed economies – and is likely to remain so for some time yet.
With China, too, now slowing down, India and Brazil struggling and Russia showing some concerning structural weakness and insularity, investors looking for growth may have to dig deeper and look to the fundamental reasons for emerging markets’ rise. “The ones that are really enjoying fantastic domestic economy growth are those that have a big demographic dividend coming from a youthful and fast-growing population,” Hopkins says. “That’s not really about China, but it is about Indonesia, it is about Thailand, it is about the Philippines. It is about countries in Latin America like Colombia and Peru.”
These are countries that have not been on the investor mainstream, but have begun to emerge, or re-emerge. Indonesia’s GDP growth has dipped below 5% only once in the past decade. With a population of more than 240 million and improvements to both political stability and macroeconomic management, the country has notched up big inflows of foreign direct investment. The countries around it – notably Thailand and the Philippines – have had a more difficult time during the downturn due to their closer links with China, but also represent large consumer opportunities.
Goldman Sachs’ O’Neill included Indonesia in his Next 11. What unifies these countries is not just the size of their populations, but the emergence within that of a more affluent middle class which is consuming more, giving these countries domestic, as well as external, drivers of growth.
Buoyed by close to a decade of uninterrupted growth, other sub- Saharan African countries have also started to drift on to investors’ radars, although their bond markets are poorly developed and their equity markets are highly illiquid. Those few investors who did follow the hot money into sub-Saharan stocks before the crisis were burned. Ghana was home to the best performing stock market in the world in 2008, with its main index up more than 63% over the year. In 2009, it was the worst in the world, crashing nearly 50% as investors dumped frontier market equities. (Pictured above, the former US treasury secretary, Henry Paulson, visiting the Ghana Stock Exchange in Accra.)
“I think some of these [opportunities] are illusory. We like sub-Saharan Africa,” FF&P’s Briggs says. “We think it’s a really interesting theme, but you have to recognise that the liquidity in that part of the world is very, very seriously constricted. And it will take you a very long time to put the money in. If things go well, that’s great. If things don’t go well, you’re literally stuck.” In the volatile post-crisis world, liquidity is still a primary consideration. However, more liquid investments in, for example, emerging markets exchange traded funds, fall victim to the fact that indices have performed badly, and do not necessarily capture the more interesting opportunities in emerging markets.
“We’re not really turned on very much by indices. I think they’re very dangerous, because they tend to reflect the weight of money that’s chasing these things,” Briggs says. The kinds of companies that follow the consumption theme, in consumer goods, insurance, healthcare and savings, tend to be smaller. “They’re really out of bounds for the quite large funds that need to deploy quite large sums of money fairly quickly,” he says. “We like to think we’re more nimble than that.” Hopkins concurs. “ETFs are highly indiscriminate capital that flows in and out of these markets as part of the risk-on, risk-off trade mentality of institutions today. And the big benchmark funds, they move marginally around the index, but essentially they are the index,” he says. “If you follow that approach, you will probably not benefit from the real opportunities of emerging markets.
“For example, if you invested into Brazil through a benchmarked product or an exchange traded fund, 42% of your capital would go into two big stocks – Petrobras and Vale. One’s a mining company and one’s an oil company, so they have nothing to do with the domestic story, which Brazil is all about, with 95% of the GDP coming from the domestic economy.” Briggs, like Hopkins and Armist, prefers specialist managers to run emerging market money, believing that specific opportunities in smaller, less liquid markets are best captured by those who really know the lie of the land.
Mark Mobius, executive chairman of Templeton Emerging Markets Group, one of the largest emerging markets investment houses, disagrees. “There is no reason to believe that global emerging market funds cannot capture the opportunities in emerging markets,” he says. “In fact, having a global mandate allows the fund to invest in any market or sector or company based on where the portfolio manager views the most attractive investment opportunity, rather than be restricted to a particular set of markets or sectors. Of course, as an investor, one must conduct their own due diligence on a fund before making an investment.”
For investors still cautious in a difficult global environment, emerging market exposure can be achieved by investing in developed world businesses that generate significant revenue from high-growth regions. Consumer brands, from McDonald’s to Unilever, continue to expand globally and offer proxies with developed world corporate governance and liquidity.
But for more adventurous investors, or those with a longer-term horizon, there are other opportunities to access this growth. For intergenerational investors at family offices, who perhaps have less immediate liquidity requirements, taking a strong view on underlying economic growth can lead to good returns.
“You have to be something of a contrarian in the emerging markets space,” Hopkins says. “You have to take a medium to long-term view when you are allocating money into more illiquid markets. But if you do, you’ll be well rewarded.” He, with several partners, successfully raised a fund to invest in a greenfield shopping mall project, the Grand Towers Abuja Mall, in Nigeria’s capital. The country’s 162 million people are rapidly urbanising and an aspirational, acquisitive middle class is emerging. Building modern retail outlets to meet this huge latent demand is, for those willing to stomach both the project risk and the long-term outlay, a good earner.
“There are opportunities to invest in very high-return projects,” Hopkins says. “The anticipated internal rate of return of the shopping malls that we are building in sub-Saharan Africa is in excess of 40%, and the counterparty risk is rather modest. The people who are building them are Group Five, the largest construction company in South Africa. The quantity surveyors are CBRE and Broll. These are reputable companies.
“That’s an investment opportunity – it’s not an equity investment opportunity – in Nigeria, but it is a real investment opportunity, really benefiting from the fast growth of the consumer component of the economy.”
More entrepreneurial family offices have increasingly been dipping their toes in the water of emerging and frontier market private equity, testing out the theme and taking advantage of their relative long-termism to gain a liquidity premium on their investments.
“People are still anxious about 2008, when they saw their net asset value dropping substantially, and therefore sometimes simplicity, liquidity and transparency is what wins the day in their investment horizon,” says Armist, who has put money into Chinese private equity on behalf of his clients. “But one can certainly make quite a strong case that because people are afraid of illiquidity and shy away from it, that’s where you can get some quite interesting opportunities.”
Definitions and history
The economist Antoine van Agtmael claims in his book The Emerging Markets Century, published in 2007, that he coined the term emerging markets in the 1980s. Some might dispute this, but there is little doubt that the term entered the vernacular of investing in the 1980s when some of the now well-known emerging countries like China and India began to deregulate their economies and investors began smelling opportunities.
But it wasn’t until the 1990s that the universe of emerging markets really took off. The newly liberated former communist states of eastern Europe and the downfall of the Soviet Union captured investors’ imaginations. But most avoided these frontier markets, piling instead into the rapidly growing economies of Asia, especially Thailand, Indonesia, Malaysia, South Korea and Taiwan. Investor sentiment can be fickle as any fund manager can testify. The onset of the Asian financial crisis in 1997 saw investors nursing big losses, leading to many questioning the wisdom of emerging markets in the late 1990s.
Investor sentiments also turned away from the asset class in the late 1990s as the dotcom boom got underway. It wasn’t until well into the next decade that emerging markets began to interest mainstream investors again. This time it was the so-called Brics – Brazil, China, India and Russia, a term invented by Goldman Sachs economist Jim O’Neill in 2001 – that fired up investor enthusiasm for the concept.
The financial crisis of 2008 and the subsequent slowdown of many of the big industrialised economies appeared to prove that emerging markets, or at least a few of them, had decoupled from the economic cycle of the big western economies. The Chinese, Indian and Brazilian economies pretty much continued to grow rapidly despite the slowdown in Europe and the US. That convinced many investors to up their asset allocation to the big emerging markets.
But this reasoning is now itself under scrutiny as the Bric economies look more vulnerable and begin to slow down. Add to that the complication of the massive economic problems in places like Greece (pictured left in October, when Merkel's visit sparked protest), Spain and Portugal, and the emerging market concept is now beginning to look tired. The term frontier markets is now being increasingly used, which is partly a result of all the turmoil of recent years but also because many feel the Brics no longer offer emerging market-like returns. They have effectively become developed markets.
That’s probably why economists like Goldman’s O’Neill now talk about the Next 11 – Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey and Vietnam.
And no doubt influenced by the old O’Neill acronym Bric, Robert Ward of the Economist Intelligence Unit came up with the term Civets to describe the investment opportunities offered by Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa.
The collapse of Lehman Brothers, fears over the stability of European banks and client money being lost at a number of supposedly reputable financial institutions have brought to the fore the issue of counterparty risk.
“Clients are becoming better educated on this. That applies to all of us. Every meeting I have with clients, counterparty risk is on our agenda and we discuss it. If we didn’t bring it up, they would,” Ronnie Armist, executive director at Stonehage, says. “They’ve diversified their custodians and counterparties, which is something that we’ve encouraged. When you get into emerging markets, that becomes a big issue as well.”
At Milltrust International, chief executive Simon Hopkins advises clients to use managed accounts to mitigate the risk of losing their money if a counterparty collapses. “If a manager goes bust or does something wrong, we don’t have to ask for our money to be returned to us in a polite redemption request,” he says.
When emerging markets represented a small proportion of an investor’s overall portfolio they were less concerned about their counterparty risk. Local custodians may not meet international standards in terms of financial stability or the commingling of client assets with their own balance sheets, or they may simply not understand the reporting and communication requirements of global investors.
“Why would you give your money to someone in Latin America, even if it is a big bank?” Hopkins says. “I think you would have enormous trepidation if you went to China and said right, I am going to give a huge sum of money to any of the local players, because they’re just not proven in terms of their governance or their understanding of what international managers expect... People don’t want to allocate to a name they’ve never heard of in a country that they have concerns about, even if the stock market is going to go through the roof.”
Illustrations by David Lyttleton
Pictures copyrighted to Press Association
This article was amended on 27 November, changing Mark Mobius's position to executive chairman of Templeton Emerging Markets Group