We at Investec Asset Management believe that emerging economies are still in the early stages of a half-century-long catch-up with the developed world. Several factors are driving this process, most notably greater reliance on market mechanisms, the diffusion of technology and broad improvements in political governance and stability. The next phase of emerging-markets growth, however, will mean a different set of challenges for these economies: namely, how to ensure broad-based development of institutions, political structures and corporate governance in an environment in which economic growth is shared by a large swath of the population. Essentially, rather than the quantity of growth, investors should be thinking more about the quality of economic expansion and development.
Over the past ten years, when assessing the attractiveness of a given economy, the investment community has focused on the level of economic growth in emerging markets, specifically any rises in gross domestic product. But not much interest has been directed to the sustainability of this growth or its distribution within society, both of which are key components for the long-term development of an economy. Over the short term, aggregate economic growth is not a sufficient driver of investment performance, both on the equity and on the fixed-income sides. Historically, there has been an insignificant relationship between aggregate economic growth and equity returns. There are many reasons for this, including:
• GDP growth is a backward-looking statistic, whereas equity markets show the present value and look toward future growth and earnings.
• GDP measures one nation’s economic output. Stock market indexes — in emerging as well as developed markets — reflect earnings for numerous countries, a key measure in the globalized economy.
• Equity returns correlate more with the bottom line, whereas GDP is more closely associated with the top line. Many emerging markets have not been able to translate expansion in gross sales and revenues into net earnings.
• GDP gives little sense of the distribution of economic growth within a society, that is, who is actually benefiting from a country’s total increase in output. Over the long term, though, there is likely to be a stronger connection between GDP and the distribution of economic growth, but investors should be wary of equating the two because one doesn’t necessarily lead to the other.
The process of development in emerging economies is likely to be enduring, driven in part by expectations of rising living standards. The path of development is neither smooth nor universal. But in most countries, any faltering or reversal of momentum should result in renewed pressure to accelerate market-based reforms. Such an impetus will come not just from the international community but, more important, from populations increasingly able to compare their fortunes with those of people in similar countries.
With risk and volatility, perceived or real, being the price of the opportunity for excess returns, investors will need discipline, which means country-by-country, sector-by-sector and company-by-company analysis. Understanding the various elements of development will help investors find attractive investment opportunities in both public and private markets. With the postmillennial period of high returns across the board unlikely to be repeated, optimizing this yield will require a more active approach to emerging-markets investing. This strategy, in turn, requires intensive research, analysis and due diligence combined with flexible asset allocation. This approach may deter investors hoping for the utopian world of easily earned premium returns: low risk, low cost, low volatility and high liquidity. For long-term investors who understand the changing nature of investment opportunity, we believe fortune will continue to favor the bold.
Philip Saunders is a portfolio manager at Investec Asset Management in London.
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