The New Reality: Emerging vs. Developed Markets

08-Nov-2010

I like this.

By







Sara Zervos

Vice President and Portfolio Manager

The financial turmoil of the last three years has exposed structural weaknesses in developed markets and fundamental strengths in emerging markets. Yet, many investors still automatically associate developed markets with relative stability, and emerging markets with risk and uncertainty.

This issue of Focus on Global Fixed Income reassesses commonly held assumptions about both categories and examines how several far-reaching factors have aligned in emerging markets’ favor, including

  • Policymaking
  • Deficits and debt levels
  • Inflation
  • Economic growth
  • Demographic trends

Setting the stage

Reforms and prudent policymaking have set the stage for emerging markets to adopt a growing presence in relation to developed markets.

Thanks in part to their glowing performance in the aftermath of the credit crisis, emerging markets (EM) are garnering more investment focus than ever before. There is no denying that developing countries are responsible for the short-term rebound in global gross domestic product (GDP) and trade that followed the financial crisis of 2008. In 2009, emerging markets’ GDP grew 1%, while the developed economies averaged an abysmal –3.4%.1  This outperformance will not remain an isolated event in the global economic history books.

Reforms and prudent policymaking have set the stage for emerging markets to adopt a growing presence in relation to developed markets (DM). In most cases, the fiscal situation in the former outshines that of the latter, debt ratios are stable or falling, and economic stability has become the norm. While democracy is taking a stronger hold in the EM world, central banks there have fostered generally stable and low inflation, and governments have been able to run counter-cyclical monetary policy to smooth out the old boom/bust EM dynamic. Finally, the stark contrast between EM and DM demographic profiles show that emerging markets are poised to be the voice and the driver of the future. Below, we highlight the factors that put developing countries in such a prominent role.

The fiscal tables turn

Of the many pernicious effects of the recent credit crisis, the poor fiscal position of many countries is currently the most prominent in investor’s eyes. The uncovering of Greece’s particularly horrible debt and deficit figures set off a wave of worry, and analysts have pored over the statistics in the developed and emerging world looking for the next problem to surface. Massive government stimulus programs, along with poor economic growth (and thus tax revenues), have brought fiscal deficit numbers to near-historical levels. In addition, large and growing debt-to-GDP ratios in various countries are raising questions about the viability of economic recovery, and in some cases, whether certain countries can sustain their debt loads in the future. However, even a cursory look across countries shows that unlike past crises, this problem sits almost squarely within developed economies. While EM arguably still lags DM in institutional development (such as their legal, regulatory and political frameworks), when judged on typical credit metrics, emerging markets appear the bastion of creditworthiness.

The chart below gives a snapshot of key debt-related figures across both developing and developed countries. Given Greece’s membership in the euro, and the ongoing discussions about the viability of the eurozone, the chart also shows how various countries perform relative to two key aspects of the Maastricht criteria for membership in the currency union: Deficit-to-GDP ratios of less than 3% and debt-to-GDP ratios under 60%. Over the past 5–10 years, emerging markets on the European periphery have been viewed positively as they get closer to achieving the Maastricht criteria, and have seen their bond yields pressured higher when policy actions take them further away from membership.

The chart illustrates just how far the actual euro members are from their own criteria, and even more striking, just how well emerging markets across the globe compare. Mexico, Indonesia and Brazil seem best behaved; they have not blown out their budgets, and their debt loads are relatively low. Greece appears in the worst shape, along with other members of peripheral Europe (Portugal, Italy, Spain). Japan has such a high debt load (209%) it is literally off the chart! The U.S. is also in an undesirable position.

This snapshot provides several insights into what investors can expect of each country in terms of

  • The need for fiscal austerity measures
  • Their ability to repay debt
  • The risk premium that must be placed on their debt

Clearly, Japan has shown its ability to service such a large debt load, even with sluggish growth. However, even basic sustainability analysis with generous assumptions shows that Greece’s situation is untenable.

At the opposite end of the spectrum lie the emerging markets. With the exception of Hungary, most of these were growing above potential when the crisis hit. In addition, most were in great fiscal shape, interest rates were high and debt ratios were falling, thanks to prudent policies, inflationary pressures and booming trade. Thus, as the crisis brought economic activity to a halt globally, emerging market governments and central banks, unlike their DM counterparts, were comfortably able to run countercyclical fiscal and monetary policies without decimating their public accounts or taking on massive new debt.

Consequently, emerging markets are now the drivers of global economic growth. Clearly, China is a leader in this respect, but other Asian economies and Brazil are leaders as well. International reserve accumulation continues in emerging markets due to inflows and the attempt by EM central banks to stem the tide of foreign exchange appreciation. These reserves effectively act as insurance for the countries, helping guard against future episodes of risk aversion and improving the ability to repay debt. In short, reserves improve the ability to repay debt. All in all, the emerging world is in very good absolute shape, but especially so relative to richer countries.

Conquering Inflation

In addition to EM governments’ recent spate of fiscal prudence, deeper institutional changes and reforms over the past few decades provide emerging markets with a solid foundation for perpetuating high growth rates and eventually converging with the developed world. In the 1970s and 1980s, many developing countries were plagued by hyperinflation. Brazil, for example, had to change the fiat currency six times from 1967 to 1994 so that people wouldn’t have to push around wheelbarrows of cash in order to transact. And high inflation was so much the norm in Turkey that companies used special inflation accounting techniques and three sets of accounting books, while dollar indexing was widespread.

The 1990s brought a new awareness that inflation is the enemy of the poor. With a backdrop of low and stable inflation in the rich countries, central banks in emerging markets began adopting stricter inflation-targeting frameworks, some with dual mandates to foster economic growth, but always containing some measure of price stability. Government leaders, such as President Luiz Inácio Lula da Silva of Brazil, saw the importance of maintaining low inflation for their own popularity, and gave more independence to central banks.

These initiatives paid off. This next chart dramatically illustrates how much average inflation dynamics have changed, and how key emerging markets have succeeded in managing inflation toward developed country standards.


Inflation in most emerging markets has plummeted over the last 10–20 years, converging to levels near those of their developed-world counterparts.

The chart shows average inflation over the last four decades across a host of important emerging nations. Following hyperinflation in Brazil in the 1980s, and very high inflation in Russia, Turkey and Brazil in the 1990s, inflation in most emerging markets has plummeted over the last 10–20 years, converging to levels near those of their developed-world counterparts.

The next chart highlights the most recent consumer inflation figures. Clearly EM central banks—and in many cases, governments— take inflation fighting very seriously.

Growing EM middle class should drive demand far higher

Emerging market debt and equities deserve a permanent focus as asset classes due not only to the fiscal health of the developing world, but also to its growing share of world GDP and the effects of global demographics (which we’ll address in the next section). As mentioned previously, EM countries are growing fast, and they represent an increasing share of world output and demand. Higher rates of economic growth are pulling populations in the developing world out of poverty, leading to a rapidly expanding middle class.

chart image: Emerging Market Inflation Now Approximates that of Developed Markets

A World Bank paper2 uses simulations to predict some amazing shifts in the global middle class:

  • Thanks to emerging markets, by 2030, an estimated 16.1% of the world population will be categorized as middle class, up from 7.6% in 2000
  • Over the same period, emerging markets will account for 750 million new entrants into the middle class
  • While in 2000, 13.5% of the global middle class was Chinese and only a negligible amount Indian, by 2030 these two groups will account for an estimated 44% of the global middle class— with Indians moving from virtually zero to 6%

These changes represent a huge increase in buying power, since individuals above the poverty line have disposable income for all sorts of consumer goods and services. Investors would be wise to focus not only on the countries that are driving this change, but also on companies that serve this growing consumer base.

Younger EM population should drive productivity gains

The developed world has a strike against it in the arena of demographics as well. Even though fertility rates appear to have bottomed in advanced economies, there still will be decades ahead where an aging population puts an increased burden on the working population in these countries.

According to United Nations estimates3

  • The ratio of U.S. citizens age 65 and older relative to the working population will increase from an average of 16–19% over the period from 1965–2009 to a whopping 32% by 2030
  • In Japan it will move from about 37% to 57%
  • In the Euro area, the percent will shift from roughly 29% to 45%

The next chart compares old-age dependency ratios for developed and developing countries, using United Nations data and definitions. This ratio is defined as the ratio of the population over 65 years of age to the population between the ages of 15–65, indicating the size of the older generation that must be supported by the younger, working-age one. As the following graph shows, the ratio in DM is much higher than in EM, and the difference is likely to grow in the future.4

chart image: Developed Market workers will have to support a larger population of over-65s than Emerging Market workers

On a percentage basis, richer countries already have over twice as many over-65s to support as developing nations do. Furthermore, the working population generates growth, while the older population drains savings. The young workforce is more likely to generate productivity, maintaining a higher rate of GDP growth in developing countries. Finally, in developed countries, fewer people will be working to support older, non-working retirees, and as the pension systems are not fully funded, this will create an increasing fiscal burden.

Summing up: These are not your parents’ emerging markets

The financial crisis of the past few years offers many lessons to investors. In the aftermath of Lehman Brothers collapse in September 2008, investors sold risky assets across the board, either out of fear, or out of a genuine need to deleverage. In this period, emerging market assets,including bonds and equities, suffered dramatic losses.

Yet, as the next chart shows, a year and a half later, emerging market credit default swap (CDS) spreads—an indicator of perceived default risk—are near their tightest historical levels after suffering a dramatic widening during the initial crisis period. (Note that the bottom of each country’s line shows the level of its 5-year CDS spreads in January 2008, the top of the line shows the widest level in the period since, and the circle is the most recent data point as of May 24, 2010.)

chart image: emerging markets show ability to weather major storms

While developed country spreads are also much tighter than they were at the beginning of this period, they are less likely to see total recovery in the near term. A primary reason is that their credit metrics have suffered a significant blow that is unlikely to be rectified for many years, even with abundant global liquidity conditions.

The lesson is: These are not your parents’—and certainly not your grandparents’—emerging markets. Emerging economies have shown their ability to weather major storms, and investors would be wise to adopt a long-term view of these assets’ potential.

1. Source of data: JPMorgan Research, 5/25/10.
2. Source of data: Bussolo, De Hoyos, Medvedev, van der Mensbrugghe, Global Growth and Distribution: Are China and India Reshaping the World? Policy Research Working Paper 4392,11/1/2007.
3. Source of data: United Nations Population Division, 5/25/10.
4. China’s case is an exception, where the one-child policy will haunt the demographic trends in the more distant future.

https://www.oppenheimerfunds.com/articles/article_06-02-10-113016.jsp


Tags: , ,

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

Subscribe without commenting