Eric P. Leve, CFA is Chief Investment Officer and an Executive Vice President of Bailard.
March 31, 2019
We’ve all seen the feel-good movie: the hard luck kid (probably endowed with a good heart) is running off the rails or getting beaten up. The kid meets a generous guide, who is older and wiser, and by fits and starts the unpolished rogue matures into a true hero. It’s an upbeat framework but, unfortunately, the narrative isn’t a natural fit for the coming of age tale of emerging market equities. The International Monetary Fund (IMF) has rarely proven to be that wise mentor: the trajectory for emerging markets has been more nuanced than the model of The Karate Kid.
If one were to distill the history of emerging markets (EMs) into the shortest of stories, it might read: in the 1980s they were a novelty, in the 1990s they were engaging, in the 2000s they were profitable and in the 2010s they’ve been a disappointment. Alternatively,
investors may have initially viewed emerging markets as a space where only cowboys tread. Then their perspective turned to hold EMs as a place to bolster investment returns relative to U.S. stocks and developed market non-U.S. stocks. As some disappointment set in, the narrative became that well-timed bets could generate outsized returns and then, most recently, EMs became a place that teases but perennially disappoints.
Yet, there are at least two other narratives that better describe the evolution of these less developed equity markets. Both scenarios rely on a backdrop of economic development: one mainly regional and the second global in scope.
When a Region Comes into its Own
The regional plot focuses on Asia, where cubs have prowled and grown into tigers. Here we speak of countries that enjoyed world-beating economic growth for most of a generation. Then, having built an industrial base, these countries relished standing as market leaders for a time afterward. In this queue, Japan came first, with its post-WWII economic boom that generated annualized economic growth in excess of 9% rather consistently though the early 1970s. Like all nations that play catch-up, though, Japan’s growth eventually returned to global averages. A similar story can be told of their equity market but, critically, with a lag. This is the general character of quickly-industrializing markets: first, you get the economic growth but modest stock market returns, followed by an extended period when the equity market is a world-beater. Japan’s great run of equities lasted through the end of the 1980s but has brought little cheer since.
Most recently, EMs became a place that teases but perennially disappoints
Singapore moderately bucked the trend set by Japan, with its great economic run extending roughly ten years beyond Japan’s. Singapore’s equity market managed to enjoy strong returns during its economic growth period, but also faltered through the mid-1990s when the Asia Crisis brought down equity markets both strong and weak. Taiwan suffered the same fate with its world-beating returns through the 1990s. For the ten years ending in 2007, South Korea’s equity market produced 31.2% annually as its electronics, container ships and cars became ubiquitous around the globe.
Today, China’s economic growth has been in secular decline since its spectacular surge began slowing in 2010, the last time the nation achieved real GDP growth in excess of 10%. That growth has now slowed to near 6% and is likely to converge further with tepid global growth over the next decade. And while Chinese equity markets experienced several spectacular years of returns in the mid-2000s, those highs have been nearly non-existent since.
But history tells us when nations invest, build and generate strong GDP growth, equity returns will follow. This is consistent with how returns accrue to individual companies as well: capital spending tends to point to weaker returns in the near-term but stronger returns ahead. And so, in many ways, the next emerging market “miracle” is likely to be China. Amid the wheat and the chaff of Chinese equities, stocks trading on the mainland have historically been the domain of relatively-uninformed individual Chinese investors. Global institutional investors are now rushing into newly formed trading channels, providing foreigners access to a universe of more than 1,300 mainland stocks.
A More Global Tale
The second story line of growth economies becoming successful equity markets is one based on demographics and changes in economic drivers. In the traditional model of economic development, countries follow a path from the markets being driven by agriculture, then by industry and, finally, by services. Agriculture based markets tend to produce more children, and have a generally-younger population than those driven by industry or services. A source of commodities in the ground can also smooth the path from agrarian to industrial for many markets (consider much of Latin America). During that transition from an agricultural to an industrial focus, the abundance of youthful workers can be a tailwind, yielding lower-cost manufacturing.
As China is now losing the role of low-cost exporter to the world, several markets seem poised to fill that gap. The most likely near-term replacements are Vietnam and, surprisingly, Indonesia. Vietnam is rightfully touted as having a young, highly literate and energetic workforce. It still fails to provide good access to their stock exchanges in Hanoi and Ho Chi Minh City. But as development in Vietnam’s financial sector catches up with its manufacturing prowess and capitalistic zeal, investors in Vietnam could enjoy a good run.
Indonesia is very much the ruffian who has tried to make good and failed several times. It is generously endowed with oil, gas, gold and many critical base metals, but the country has never punched at its weight as a commodities exporter. One reason has been a deplorable lack of transportation infrastructure to get goods to ports. Under current president Joko Widodo (“Jokowi”), this has improved. Happily, Jokowi appears to be the least corrupt leader in the nation’s history, yet his efforts to make Indonesia globally competitive aren’t as focused on the export of raw materials as during the previous “golden time” for Indonesia in
the mid-2000s. This time the infrastructure will go to moving finished goods out of the vast archipelago and could be the jolt that fires Indonesian equities for years to come. This is the backstory for Indonesia’s sequel.
Beyond Asia there exists a spectrum of potential for where investors may turn their attention. Nigeria has been touted as the “next” market for over ten years. Unfortunately, even with a young population, Nigeria’s political and governance structures will probably not move beyond that same description for another decade or two. East Africa has developed quickly with the help of Chinese capital and Kenya has many aspects that may propel it up the league tables over the next decade. In the near term, the best opportunities remain
as described above: markets where governance has improved and where economies and the equity markets have evolved to capture the full range of commodities, goods and knowledge-intensive industries.
Emerging markets are not homogeneous. Though EM returns have been dispiriting in the past decade, the prospects for rapid economic development and engagement with global markets—leveraged by what futurists are calling the fourth industrial revolution with the integration of man and machine in a wide range of processes—coupled with quickly-developing financial markets, makes this as exciting a time for the space as we’ve had in a long while.