Less room for growth as emerging markets mature

Emerging markets have come of age since the dawn of the new millennium; their share of the global economy has almost doubled to 25 per cent since 1999, while their contribution to world growth has averaged close to 50 per cent in the most recent 10-year period. Investors who positioned their portfolios early to capitalise on these trends have benefited handsomely, as emerging markets have outpaced developed markets by more than seven percentage points a year on average since the end of 2000.

However, emerging markets’ strong relative investment performance came to an end almost three years ago, as growth rates began to disappoint. And fears during the summer that the Federal Reserve was about to take the first step on the long road back to monetary normalisation caused some investors to wonder whether a full-blown crisis might be in store for the developed world.

The mini-crisis subsided once the Fed decided to keep the pace of quantitative easing unchanged, but concern has now shifted to growth prospects of emerging economies. It is hard to believe it is little more than 30 years since the term "emerging markets" was born. Back in the autumn of 1981, Antoine van Agtmael, a young economist at the International Finance Corporation (IFC), an affiliate of the World Bank, pitched the idea of a Third World equity fund to a group of 20-odd investment managers at the New York headquarters of Salomon Brothers.

The presentation was well received by the audience, though Francis Finlay, a respected investment manager at JP Morgan, warned Van Agtmael that he would "never sell it using the name 'Third World equity fund'!"

Stigma
The World Bank economist was not inclined to disagree; he recognised that the stigma associated with the term "Third World" – "an image rife with negative associations of . . . Soviet-style tractors and flooded rice paddies" – was unlikely to inspire confidence among the investment community. The resulting search for a more invigorating alternative saw Van Agtmael coin the term: emerging markets. Emerging markets struggled to attract portfolio investment in stocks and bonds before the 1980s. However, efforts by Van Agtmael and others raised awareness of the promising growth opportunities, and private portfolio flows increased from just $100 million in 1970 to more than $10 billion by the end of the 1980s. The surge in portfolio flows continued through the first half of the 1990s, and reached a peak of more than $100 billion in real terms by 1996, as outsized gains attracted more and more investors.

Investors were inevitably reminded of the higher risks associated with emerging market investing, as billions were lost in the Asian crisis of 1997, the Russian crisis of 1998, and the Argentine crisis of 2001. Emerging markets’ weight in the MSCI All Country World Index sank from a then record high of almost 7 per cent in 1997 to below 4 per cent by the end of 2002.

Emerging economies weathered the global financial crisis remarkably well. The combination of current account surpluses, a greater degree of exchange rate flexibility, low levels of short-term external debt and high levels of foreign exchange reserves helped shield the developing world from the worst of the external shock. Further, strong fundamentals – in concert with sound fiscal positions – afforded emerging countries the necessary credibility to pursue accommodative fiscal and monetary policies.

Growth advantage
Per capita GDP growth in the developing world outpaced advanced economies by more than four percentage points a year in the post-crisis period – as compared with a pre-crisis growth differential of about 2.5 percentage points. Not surprisingly, the growth advantage – alongside favourable interest rate differentials – precipitated a surge in net private portfolio flows from about $600 billion in 2009 to $1 trillion in each of the subsequent three years.

The favourable trend in portfolio flows looks set to be reversed, however, as concern over emerging economies’ growth prospects continue to mount. Growth rates in both developing Asia and Latin America have declined by roughly 3½ percentage points since 2010, and average growth rates since the global financial crisis are about two percentage points below the rates of increase registered in the pre-crisis period.

The relatively disappointing growth rates are the result of headwinds that are unlikely to disappear anytime soon. First, the financial crisis brought an end to the debt-driven model that underpinned economic growth throughout most of the western world for at least two decades, and this development undermined the export-led growth model, which many emerging nations pursued so successfully in the past. Indeed, global exports have flatlined since the second quarter of 2013, and emerging market exports have grown at an average quarterly rate of just 0.3 per cent, as compared with a 4.6 per cent growth rate in the early 2000s. Export growth to the developed world is likely to remain lacklustre in the immediate future, while the rebalancing of China’s economy towards domestic consumption means export volumes could continue to disappoint over longer horizons.

Second, the rapid accumulation of debt on private sector balance sheets means that historically low interest rates may do little to stimulate domestic demand. Indeed, non-financial private sector debt relative to GDP in emerging Asia is rapidly approaching the peak registered before the crisis of 2007, while private sector credit growth has exceeded 10 per cent in each of the past three years for a large swathe of countries including Brazil, China, India, Indonesia, Russia, Thailand, and Turkey. Emerging markets have come of age in the current decade, but investors should be aware that the relatively disappointing growth rates of recent years are here to stay.