After eight years of unprecedented economic growth and equity and bond market strength, investors have started to question whether emerging markets will be able to maintain their positive momentum.
Annual inflows into emerging market funds reached record levels of more than $15-billion last year. Flows for the first three months of this year have already surpassed this, having reached $22-billion. Emerging markets, as an asset class, cannot be ignored. Simply measuring the world in dollar terms, the developed economies make up 68% of total output by gross domestic product (GDP).
This superficial measure, however, is distorting. A more accurate measure is to calculate GDP in purchasing power parity (PPP) terms. South Africa is a good example of why it is important to use PPP calculations. When the rand blew out in 2001 you might not have wanted to travel abroad, but your standard of living in South Africa (and what you consumed and produced) did not change as dramatically as the dollar value of our GDP. From 2000 to 2001, South African GDP in dollar terms went down 35% and then up 44% the following year, while in rand terms real GDP increased by 2,7% for 2001 and 3,6% in 2002.
Using a PPP measure of GDP, emerging markets have grown far more significantly over the past 30 years than they have in simple dollar terms. Emerging markets have surpassed the developed world in their share of world GDP; they are now 55% of total world GDP. For the past eight years, since the 1998 crisis, emerging markets have had average annual growth rates consistently higher than that of the developed economies, with the growth differential widening to as much as 5% in 2003. Emerging markets have higher private and public savings rates and now attract a significant portion of world portfolio flows and foreign direct investment.
Investors, by choosing emerging market investments, have driven bond yields (a measure of perceived sovereign risk) down to almost negligible levels relative to that of the developed countries. Some commentators, attributing this to high global liquidity caused by low global interest rates and the desperate search for higher yielding instruments by pension funds, warn that emerging markets are at risk if global liquidity dries up. While this may be wise counsel for short-term traders, the long-term story for emerging markets remains intact.
It is true that global savings have risen as the populations of the wealthier countries age and have been boosted by the high oil price serving as a tax on the world’s consumers and a windfall for countries that have a higher propensity to save.
But that is only part of the story. Investors have become more comfortable with the political and economic stability in the emerging market world. Increased purchasing power has led to growing levels of consumption, reducing the reliance of emerging economies on export revenues from the industrialised world. Already China consumes 20% of the world’s base metals (the United States consumes 17%) while India consumes 25% of the world’s gold output. India is currently only a $600 per capita income country, China is at $1 100 (South Africa is already at $3 300 per capita, the US at $37 000).
With annual GDP growth rates close to 10%, the consumption potential of these economies as their purchasing power rises will be nothing short of phenomenal, generating the high expected returns needed to justify pricy equity markets.
Furthermore, the continued compression of bond yields reflects global investor buy-in to the long-term growth story and the perception that emerging-market risks are declining. Today emerging markets are operating under more stable macroeconomic and political environments while investor risks have been significantly reduced with the growth of hedge funds, credit and equity derivatives markets.
Within emerging markets, South Africa stacks up very well:
- the rand has been stable around fair value for the past three years;
- returns on fixed-income assets are above 7% (the US offers less than 4%, Europe below 3% and Japan about 1%);
- the equity market, having risen 55% over the past year, still lags other comparable emerging equity markets, some that have run over 100% during the same period;
- the country’s sovereign risk rating stands at the edge of reaching single A-grade status, with positive recent reviews by the rating agencies;
- foreign direct investment flows are increasing rapidly, reducing the vulnerability to short-term portfolio flows or “hot money”;
- the economy has already entered a 4% to 5% GDP growth rate, with a growing probability of reaching 6%;
- the stability of the political environment is unquestionable;
- macroeconomic policies are widely lauded as growth-positive;
- rhe strong emerging market growth story will keep commodity prices buoyant as those economies continue to build the physical infrastructure demanded by their increasingly wealthy populations;
and
- emerging market funds are positioned to increase South African assets. Relative to global emerging-market benchmarks they are currently over-exposed to Latin America, neutral to Emerging Asia and slightly under-exposed in South Africa.
Short-term emerging market jitters like those seen about two weeks ago should be used to increase exposure to this growing asset class.
Réjane Woodroffe is chief economist at Metropolitan Asset Managers