In this article Michael Power, Global Strategist at Investec Asset Management, discusses a move away from the prism of BRICs and instead frames our emerging market investing opportunity in terms of the development of regional blocs.
The BRICs (Brazil, Russia, India and China) acronym has captured the imagination of global investors like few others. But has it really helped us understand the intrinsic nature of the risks and rewards in the emerging market (EM) asset class, thereby allowing us to profit from investing in it? I have long had my doubts and recent turmoil in the asset class has only confirmed them. Is there a better way of understanding this asset class? My conclusion is that we should move away from the analytical framework of BRICs – and indeed some of the other MINTy acronyms now flavouring this alphabet soup – and instead think of EMs in terms of blocs.
There is a pressing need to do this: the paradox of investing in EMs is that – while the structural case for doing so is overwhelming – it remains an asset class that is still cyclically risky and, as such, very volatile. This suggests the right question to ask is no longer “whether” to invest in EMs, but “how”. And in answering this “how”, we must above all acknowledge that not all EMs are alike.
Having initially been drawn to the deceptively seductive logic of the BRIC approach to EMs – which essentially involved using Brazil, Russia, India and China (collectively 43% of the MSCI Emerging Markets Index)1 as the four cornerstones framing the construction of an EM portfolio – I could not help but further sub-divide this quartet into Brazil and Russia (commodity producers/manufactured goods importers with populations below 250 million) versus India and China (manufactured goods producers/commodity importers with populations over 1,200 million).
However, I have since come to realise this sub-division was, like the entire BRIC concept itself, misleading and unhelpful; it reflected the bias of “sizeism” when, from an investment perspective, there was simply no justification for doing so.
Consequently, I realised one should drop the population distinction and replace it with whether a country runs a structural current account deficit or surplus, while still retaining the second categorisation: whether a given country exports commodities or manufactured goods.
Since the Asian crisis, nearly every EM has fallen into either the “we-are-determined-to-run-a-structural-current-account-surplus” camp (the East Asians and most oil exporters) or the “we-generally-run-structural-deficits” camp (virtually everyone else). Only a few countries have crossed over from one camp to the other, and even then simply to become short-term surplus runners after a
currency crisis, only to return to the deficit camp soon thereafter. This was the case with South Africa, Turkey and Brazil after the rand, lira and real all saw sharp falls in their value in the period 2001 to 2003.
This revised approach generates the 2x2 matrix below, which – conveniently but coincidentally – just happens to have one of the four BRIC countries heading each of the four resulting blocs.
“The right question to ask is no longer 'whether' to invest in EMs, but 'how'.”
This 2x2 matrix can be populated by every emerging market and, with interesting insights arising, even every developed market. (For the sake of completeness, all emerging countries with GDPs over US$100 billion have been included in this exercise; this includes those frontier markets awaiting accession into the EM universe and the city states of Hong Kong and Singapore which have technically graduated from it).
The South-East bloc
It quickly becomes apparent that the China-centred South-East bloc qualifies as the anchor of the EM asset class (essentially because China has become the world’s largest importer of commodities, including oil, while every country in the South-West bloc is now benchmarking its wage rates to Chinas) – an observation underlined by the fact that the South-East bloc constitutes over 50% of the MSCI Emerging Markets Index. Furthermore, most other countries in the South-East bloc are East and South-East Asian and have become part of the Chinese supply chain, although this bloc does not include commodity-rich Indonesia (yet?), nor Thailand.
In addition tech-rich Israel is a bloc member, as well as Slovenia, Slovakia and Hungary – the latter trio being Central European states that are integral to the German supply chain, in much the same way as East Asia has become integral to the Chinese supply chain.
Outside China, the likes of Taiwan and South Korea (and arguably Israel) epitomise this South-East bloc: increasingly hi-tech in their export profile – their strong external trade position is bolstered by large foreign exchange reserves and underwritten by still-competitive currencies. The bloc has external accounts that are self-financing, making it largely immune to the global liquidity tide.
This results in the South-East bloc being the lowest in terms of risk and volatility, as illustrated by the fact that in the year to the end of January 2014, while it accounted for some 53% of the MSCI Emerging Markets Index, only 4% (or 41 basis points) of the Index’s 10.2% decline can be attributed to it.”²
The North-East bloc
Second, in terms of risk and volatility, comes the North-East bloc. The bloc is composed entirely of oil exporters, centred on Russia. It also includes Greater Arabia and most other members of OPEC. Russia is its weightiest MSCI Emerging Markets Index member, yet it may be the frontier market pretenders to the formal EM universe of Kuwait, Qatar and the UAE that arguably epitomise this bloc. As with all the oil exporters of Arabia, their currencies are pegged to the US dollar, allowing them to generate massive external surpluses, a sizeable portion of which is stored in their respective sovereign wealth funds. In the developed market equivalent of the above 2x2 matrix – Norway is
the sole member of this North-East bloc, holding the world’s largest sovereign wealth fund. Since 2000, what limited cyclicality there has been in oil prices has not been sufficient to force this bloc’s members out of the comfort zone of running current account surpluses into the deficit-running North-West bloc. In the year to the end of January 2014, the North-East bloc accounted for some 6% of the MSCI Emerging Markets Index and 8% (or 81 basis points) of its 10.2% decline. Interestingly, in 2013, this bloc also generated an even greater collective current account surplus than the South-East bloc, some US$445 billion over US$411 billion.³
The South-West bloc
Third, in terms of risk and volatility, comes the South-West bloc. In this are the maquiladorasto-the-developed world (including the original maquiladora Mexico, plus much of Eastern Europe), as well as nearly all of the Indian subcontinent, save for increasingly ‘East-Asian-in-character’, textile-exporting, Bangladesh. Apart from India, the other member of the Fragile Five in this bloc is Turkey. Until the liquidity tide turned in the wake of possible tapering in May 2013 – Turkey relied on the “kindness of strangers” to fund its external deficit (in 2013, 8% of GDP), a deficit which arose partly as a result of a robust, credit-enhanced consumer jamboree.
Members of this South-West bloc generally need ample global liquidity to fund their current account deficits, keep inflation tame and their interest rates low; this liquidity, in turn, underwrites expansion of their
domestic credit and consumer cycles. But when the global liquidity tide ebbs, currency risk for members of this bloc increases. As has been the case recently, currency weakness often leads to defensive interest rate hikes (Turkey up 550 basis points; India up 75 basis points) that, in turn, trips up their domestic credit and consumer cycles. In the year ending January 2014, this bloc accounted for some 17% of the MSCI Emerging Markets Index but 28% (or 286 basis points) of its 10.2% decline; falling currencies like the Turkish lira (down 22% versus the US dollar, year to 31 January 2014) and the Indian rupee (-15%) contributed significantly to this underperformance.4
The North-West bloc
Finally, the North-West bloc is the most volatile and therefore riskiest of the four blocs. It contains so-called Fragile Five members; Brazil, South Africa and Indonesia, as well as the rest of South America; its members primarily export minerals and agricultural products. Many countries in this bloc partied hard when commodity prices were robust and liquidity was plentiful, and neglected to see the deeper damage being done to the structure of their economies by the dreaded Dutch Disease (although Brazil’s finance minister, Guido Mantega, was hinting at this fall-out with his controversial but, in retrospect, not so unreasonable “currency war” comments). South Africa is a typical example of this bloc: carry-seeking bond inflows strengthened the rand, helped puncture inflation, permitted interest rates to fall and so facilitated a “consumption-cart-before-production-horse” period of
economic growth, while all the time eroding the cost advantages of what remained of South Africa’s industrial base by making its labour wage rates increasingly uncompetitive on the global stage. Result? De-industrialisation. The North-West bloc usually requires both the liquidity and commodity tides to be running in its favour to prosper. If either were to ebb, currency risk for this bloc’s members would increase. In the year ending January 2014, this bloc accounted for only 23% of the MSCI Emerging Markets Index and yet 60% (or 605 basis points) of its 10.2% decline; again much of this can be attributed to the poor performance of currencies like the Brazilian real (down 18% versus the US dollar, year to 31 January 2014), Indonesian rupiah (-20%) and South African rand (-20%).5
A new “how” to EM investing
It is clear that, in the main, there are two global tides – that of liquidity and of commodities – flowing across this matrix. One can imagine each of these two tides being governed by the waxing and waning of two distinct moons that determine where and when these tides wash up on the shores of emerging markets: for now, the American moon is primarily responsible for the liquidity tide and the Chinese moon is primarily responsible for the commodity tide.
Understanding how the ebb and flow of these two tides impact on each bloc in the matrix is what makes this metaphor useful. When the liquidity tide is flowing hard – as it has been until recently – the Western half of the matrix particularly benefits, as current accounts are more easily funded, currency risk reduced, inflation more easily
contained, and interest rates lowered, all of which unleashes the domestic credit cycle and so the domestic consumer. When the commodity tide is running – as it was in the wake of China’s post-2000 determination to upgrade its infrastructure and urbanise its economy – the Northern half of the matrix benefits from stronger export earnings. Note that, since 2000, the oil cycle has been less volatile and so more durable than the mineral cycle, meaning that, within the Northern half, the North-East bloc has outperformed the North-West.
What results is a new approach – a new “how”– to investing in EMs. This is summarised in the table below:
This methodology suggests that when we think about the “how” of investing in EM, an approach based on four blocs and not four BRICs may be a far more profitable one to adopt. This long-term strategic way of thinking does not preclude making tactical short-term recommendations – moves which very legitimately might be driven by value considerations. Rather, the idea is to create a template that can help investors avoid the worst of the fall-out, if and when, a major EM sell-off were to happen again.
Above all, it is hoped that this model can help us learn from our mistakes. This is because it compartmentalises risk and reward by identifying the specific macroeconomic drivers that cause the outperformance and underperformance of the four very distinct blocs of countries that make up the EM asset class.
Michael Power is a Global Strategist at Investec Asset Management.
“...it is hoped that this model can help us learn from our
mistaeks misteaks mistakes.”
1 FactSet, sourced from MSCI EM Country weights, as at 31.01.2014.
2 IAM calculations using FactSet, sourced from MSCI EM Country weights, as at 31.01.2014.
3 IAM calculations using FactSet, sourced from MSCI EM Country weights, as at 31.01.2014, Economist Magazine as at 31.01.2014.
4 Economist Magazine as at 31.01.2014; IAM calculations using FactSet, sourced from MSCI EM Country weights, as at 31.01.2014.
5 Economist Magazine as at 31.01.2014; IAM calculations using FactSet, sourced from MSCI EM Country weights, as at 31.01.2014.