Chapter 01

from Growth to
Development by Philip Saunders,
John Stopford, Aniket Shah
& Max King

Emerging Markets

The evolution of emerging market economies should be a key point of focus for global asset allocators today. Charting this development is not a simple task, given the diversity of economies, companies and asset classes that all fall within the broader "emerging market" umbrella. The recent volatility and under performance of many emerging market assets made investors question, not just their long-term investment, but also the way in which they think about the evolution of the opportunity presented to them. In this article, Philip Saunders, John Stopford, Max King and Aniket Shah of Investec Asset Management's Multi-Asset team outline some key development components of emerging economies that, they believe, will drive investability and returns.

The backdrop

The dismantling of the Iron Curtain and the collapse of communism in Eastern Europe in the latter half of the 20th century, was not just a major political event, but an economic one too. Centralised command-and-control economics, which had stifled enterprise, incentives and economic growth, gave way to market economics, as governments sought to mimic, rather than confront, the accepted wisdom in the West. In China, communism survived, but its leadership had already realised that the surest route to stability and international influence lay in adopting a modified form of capitalism. In the rest of Asia, in Latin America and in Africa, political and economic change was not far behind.

The result has been a long period of sustained economic growth, which has raised living standards, reduced poverty and accelerated social and political advances for most of the emerging world, alongside an exceptional era of wealth creation, comparable to growth seen in the second half of the 19th century in the US, and to the post-war period for Europe and Japan. Economic growth, which averaged 2.5% in emerging economies in the 1970s and 1980s, compared to 3.3% for developed economies, has risen to an average of 5.9% since 2000, compared with 1.9% for developed economies. Emerging economies accounted for just 16.8% of the global economy in 1990, but now account for over 50%.¹

The Result Has Been A Long Period Of Sustained Economic Growth

“The compound total return for the MSCI Emerging Markets Index from the start of 1990 to the end of May 2014 has been an annualised 7.9%, comfortably ahead of the 3.2% annualised compound return of the MSCI World Index.”

As Figure 1 shows, investors have benefitted. The compound total return for the MSCI Emerging Markets Index from the start of 1990 to the end of May 2014 has been an annualised 7.9%, comfortably ahead of the 3.2% annualised compound return of the MSCI World Index. Similarly, from 1994 (when the data series started) to the end of May 2014, the JPMorgan Emerging Markets Bond Index returned an annualised 9.8%, well ahead of the Citigroup World Government Bond Index, which returned 5.5%. The outperformance has been far from steady, with both indices displaying considerable volatility and sustained periods of underperformance.

The transition of emerging economies from stagnation to growth has not been easy. Plenty of mistakes have been made along the way; often the result of poor advice from developed market experts. These mistakes culminated in a major crisis for economies,

currencies, equities and debt in the late 1990s – recovery from which was hampered by turbulence in developed economies and markets in the early years of the new millennium. In total return terms, the emerging market equity index doubled, relative to the developed markets index, between 1990 and 1995, but then fell by two-thirds by early 1999. The subsequent nearly 12-year period included two of the worst four bear markets since 1900 for global equities. In this time, emerging market growth quadrupled, relative to developed markets.

As Figure 2 shows, between the end of December 2009 and the end of December 2013, emerging market equities underperformed again, this time by 33%. The sharp rise in developed market bond yields and emerging market spreads, combined with significant currency weakness, have made many investors fear that emerging markets are repeating the crisis of 1997-1998.

“Emerging economies are still at the early stages of a multi-generational ‘catch up’ with the developed world.”

We believe that emerging economies are still at the early stages of a multi-generational “catch-up” with the developed world. This process is being driven by a variety of factors – most notably the diffusion of technology, broad improvements in political governance and stability and greater reliance on market mechanisms.

The next phase of emerging market 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 where economic growth is shared by a larger portion of the population. We believe that investors should be thinking more about the “quality” of economic growth and development as opposed to the “quantity” of growth.

Graph 1
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Moving beyond quantity of growth

Over the past 10 years, the investment community has focused on the level of economic growth in emerging markets – namely GDP growth – as the main reason for the attractiveness of these markets. However, not much interest has been given 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 as well as fixed income side. This point has been proven by various academic studies and brokerage houses over the years, but needs to be emphasised.²

As the chart shows, historically there has been an insignificant relationship between aggregate economic growth and equity returns.

“As the chart shows, historically there has been an insignificant relationship between aggregate economic growth and equity returns.”

The reasons for this are many:

First, GDP growth is a backward-looking figure, whereas equity markets are the present-value of future growth and earnings.

Second, GDP measures a nation’s economic output, whereas in our globalised world, stock market indices – in emerging as well as developed markets – reflect earnings occurring around the world.

Third, GDP is more closely associated with top-line figures and equity returns with bottom-line figures. Many emerging markets have not been able to translate top-line growth into bottom-line growth.

Fourth, GDP gives very little sense about the distribution of economic growth within a society, and, therefore, little sense of who may be benefiting from a country’s total increase in output. Over a longer time frame, though, there is likely to be a stronger connection between these two concepts, but investors should be wary of equating the two.

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Graph 4

To move beyond GDP, we believe investors should be charting the development of emerging economies along five metrics.

We believe that these five metrics will become an important gauge of whether an economy is developing the fundamental characteristics of an attractive and sustainable investment destination.

Diversification of an economy

Over the past two decades, much has been written about the resource curse – the notion that a large natural resource endowment has stagnating effects on a broader economy. The empirical evidence for this phenomenon is mixed – some resource rich countries, such as South Africa, have stagnated in growth terms while others like Nigeria, have boomed.

As depicted below, recent research from the IMF shows that the diversification of an economy has important affects beyond GDP growth rates.3 Diversification of exports, trading partners and production is closely related to lower volatility in a nation’s output, as well as structural transformation, which is the much needed step of reallocating resources from less to more productive sectors in an economy.

These two graphs plot export and output diversification versus the volatility of output for 61 emerging economies from 1962-2010.

These findings suggest that the diversification of an economy can increase a country’s resilience to shocks and therefore sustain output with lower volatility. (As a country tends towards 0, the higher the level of diversification.)

This is important for asset allocators who are thinking about the sustainability of returns. Research on economic complexity from Harvard University, supported by Investec Asset Management, provides a tool for investors and policy-makers to chart an economy’s diversification. (For more information, see Investment Institute Journal Volume 1). Charting the evolution, sophistication and diversification of a country’s entire economy will become increasingly important for long term EM asset allocators going forward.

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Participation in economic growth

Broad-based participation in a nation’s economic growth is essential for long-term, sustainable development. Much has been written about the growing “middle class” in emerging markets. We wholeheartedly agree that this is an important dynamic for developing a growing consumer class and have identified some key figures:

• By 2030, there will likely be approximately 2.5 billion more people in the middle class, a large majority of whom will reside in Asia. Therefore, as per OECD projections, the total size of the global middle class will rise to approximately 5 billion by 2030.

• McKinsey analysts estimate that the global middle class will have an overall consumption of $20 trillion per year by 2020 – twice the current US aggregate consumption.

• The Economist forecasts that between 2012 and 2022, total private consumption in China is forecasted to nearly triple from 10 trillion yuan to 27 trillion yuan.

• Between 2007 and 2027, India’s middle class is likely to grow from 5% of the population to more than 40%, and create the world’s fifth-largest consumer market, according to McKinsey.

“The Economist forecasts that between 2012 and 2022, total private consumption in China is forecasted to nearly triple from 10 trillion yuan to 27 trillion yuan.”
Growth Map

Consumption is obviously a large part of the story. If economic growth is broadly shared, a larger segment of the population can join the consumer class, therefore benefitting business, infrastructure investments, real estate and an array of related assets that benefit from consumer spending.

However, we believe that an equally – if not more important – element of “broad-based” participation of growth is the development of an entrepreneurial class of business leaders, of all levels, in emerging markets. This is an often neglected element of the “middle class” narrative. The development of a growing cadre of business leaders will be essential for wealth creation, financial deepening, employment and other essential elements for sustainable growth of property rights and the creation of deeper and more transparent markets, which put the many on a par with the few. There are some important facts to consider about the development of an entrepreneurial class in emerging markets:

“However, we believe that an equally – if not more important – element of broad-based participation of growth is the development of an entrepreneurial class of business leaders, of all levels, in emerging markets.”

• The number of investable emerging market stocks today is 7,000, the market capitalisation of which is increasing at approximately 10% a year.

• The average ranking for the 5 largest emerging markets in the Ease of Doing Business Survey is 55 while in 5 largest developed markets it is 19.

• It takes 33 days to start a business in China, 27 in India, 48 in Indonesia, 107.5 in Brazil. At the same time, it takes 5 days in the United States, 6 days in Italy and 4 days in the Netherlands to do the same.

• In Africa today, Small and Middle Enterprises (SMEs) constitute over 90% of total business operations and 50% of employment and GDP.

“In Africa today, Small and Middle Enterprises (SMEs) constitute over 90% of total business operations and 50% of employment and GDP.”


Improvement in governance

During the past 25 years, major financial crises – India in 1991, Mexico in 1994 and Russia/South-east Asia in 1998 – have kick-started economic reform. Though growth rates may have slowed down in the short term, these episodes led to improvements in fiscal management, the introduction of productivity enhancing policies and smarter financial regulation. The improvement of governance abilities at the corporate and government level will be essential for the further investability of emerging economies.

On the corporate governance side, emerging market companies, in aggregate, are lagging developed market companies. We believe that a slow-down in top-line growth may allow many of these companies to make necessary changes to improve governance measures, as the competition for more discriminating capital – both from local as well as international sources – will increase.

On the political governance side, a wide range of reforms are needed in many emerging economies. Of course, each country has its own set of problems, but there are a few common challenges that will require an improvement in public policy in many key economies including India, China, Brazil, Indonesia and Mexico:

1) Investment in productivity enhancing reforms, leading to high quality, broad-based employment;

2) Technological upgrading of infrastructure, particularly in urban areas;

3) Fiscal discipline, despite structurally lower borrowing costs for many emerging sovereigns;

4) Continuation of public investments in human capacity development.


Development of
local savings pool

In general, higher volatility in debt and equity markets is a consequence of insufficient domestic ownership of securities. This makes emerging markets dependent on capital flows from developed markets – and developed markets are volatile and influenced by monetary policies and the behavioural biases of developed market-based allocators of capital. Since the early 2000s, gross capital flows to emerging markets have nearly quintupled. This process has been even more remarkable since the global financial crisis.

As can be seen from the charts, the portfolio flows component of total capital flows has been the most volatile and has risen sharply.

All of this is happening in a context of increasing savings rates within emerging economies. By 2017, emerging economies will make up a greater share of global savings than developed economies, and will be sitting on approximately $150 trillion of capital stock.

How these savings are accumulated and invested is, therefore, a central question for the long-term development and investability of emerging economies. One specific element of this is the development and deepening of local savings pools. The chart below from the International Monetary Fund (IMF) shows that there has been significant financial deepening in emerging markets

from 2001 to today. However, at the same time, there is still significant catch-up to be done compared to advanced economies.

There are successful models that can be emulated. Chile, for example, was one of the first emerging nations to introduce a national pension fund that channelled local savings into local equity and bond markets, as well as infrastructure investments. Academic research has shown that an increase in the number of local investors is associated with decreased volatility, but there are challenges with this relationship as financial deepening is often coincidental with financial integration.

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Radar 1
Radar 2

Development of
human capital

We believe that the continued development of human capital will become an increasingly important indicator of the future trajectories of emerging economies. There has been a lot of progress to date. For example, enrolment in primary education in emerging countries increased from 82% to 90% from 2000 to 2010. During this same period, there was an increase of over 135% in higher education enrolment in major emerging economies. It is clear that human capital is being developed in a significant way throughout the emerging world. In 2000, the United States and China produced roughly the same number of college graduates. By 2020, China is expected to produce close to three times the number of college graduates as the United States, while 40% of the world’s college degree earners are expected to hail from China or India.

However, there is still a significant gap between the health standards and educational attainment in many emerging countries, compared to developed markets. Africa is behind the rest of the world in education standards and health outcomes at all levels.

The same can be said for large portions of the population of India, 40% of which still live under the international poverty line of $1.25 income per day.

Graph 7

Continued improvements
in human capital

To understand the importance of human capital in long-term development, we believe that Professor Dani Rodrik of the Institute for Advanced Study gives some useful insights in a recent publication.4 Rodrik argues that while rapid growth is possible for short periods of time – through structural transformations of the economy, from agriculture to some form of manufacturing – sustainable development requires human capital transformation and institutional consistency. Much of the recent emerging market growth spurt, particularly in East Asia, can be explained by a rapid rate of industrialisation. However, the key challenge for this region – and for countries of a certain level of development, will be whether they can upgrade their human as well as institutional capabilities to allow for sustained growth (bottom-right of the table).

As emerging economies continue to develop, we need to understand how the development of human capabilities is also evolving.

This will mean understanding – both quantitatively and qualitatively – local educational systems, research centres, innovation hubs, health outcomes and other measures that help investors get a sense of human capital development. Investors will need to understand which countries are capitalising on improvements of human capital and what they are doing – from the development of an entrepreneurial society, growing consumer class and other benefits of improved human capabilities.

Graph 8


The process of development in emerging economies is likely to be enduring, driven by the expectations for rising living standards. The path of development will be neither smooth nor universal but, in most countries, any faltering or reversal of momentum should result in renewed pressure to accelerate market-based reforms. This will come not just from the international community but, more importantly, from populations increasingly able to compare their fortunes with progress in similar countries. With risk and volatility, perceived or real, being the price of the opportunity for excess returns, investors will need discipline.

This means country by country, sector by sector and company by company analysis. Investors would be well-advised to look beyond simple explanations about the attractiveness of emerging markets. These economies are highly differentiated, with diverse drivers of development, growth and returns. Understanding the various elements of development will help investors find attractive investment opportunities in both public and private markets.

With the post-millennial period of high-across -the-board returns unlikely to be repeated, optimising returns will require a change of gear in emerging market investing and a more active approach to investing.

This, in turn, requires intensive desk research, analysis and due diligence combined with flexible asset allocation. This 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 investment opportunity, we believe fortune will continue to favour the bold.

“For long-term investors who understand the changing investment opportunity, we believe fortune will continue to favour the...”

Philip Saunders, Aniket Shah, Max King and John Stopford are part of Investec Asset Management’s Multi-Asset team. Max is a portfolio manager, Philip and John are co-Heads of Multi-Asset, and Aniket is an investment specialist and member of the Investment Institute.

1 IMF.

2 Jay Ritter. “Economic Growth and Equity Returns.” 2004; Elroy Dimson, Paul Marsh and Mike Staunton ABN Ambro Global Investment Reports.

3 IMF Policy Paper. “Sustaining Long-Run Growth and Macroeconomic Stability in Low Income Countries – The Role of Structural Transformation and Diversification.” March 2014.

4 Dani Rodrik. “The Past, Present and Future of Economic Growth.” default/files/upload_documents/GCF_Rodrik-working-paper-1_-6.17.131_0.pdf.

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