Emerging Market Growth Narrative Collapsing
The second half of the last decade was a golden opportunity for emerging market equities to break out in a bull run not seen since the years leading to the Great Financial Crisis. The collapse in commodity prices following 2014 was a blessing for many frontiers and emerging markets. Western consumers, who were not burdened by higher inflation, spent more on imported electronics, textiles, and other products from Southeast Asian countries. Growth in many frontier and emerging market countries exceeded 6% as countries moved up the export value chain and implemented improved service-based economies. Emerging markets alone account for around two-thirds of global GDP growth, which in turn helped foster superior global economic conditions.
The sentiment was heating up again, similar to the previous bull run cycle, yet equities traded at a discount to other global markets during these years. In the past, certain emerging market equities, such as BRIC countries, traded at over a 20% premium to global markets in 2007. Moreover, around 75% of the annual returns of the MSCI Emerging Markets Index were at double digital levels between 1998-2018. However, rising political risks and a new economic cycle filled with inflation and slower growth have created new issues, and referencing the cycle from previous decades is no longer appropriate. Much of the inflation in commodity prices seen in the past twelve months has been attributable to supply chain disruptions. This trend differs vastly from the previous two decades when inflation resulted from rapid growth in China and other emerging markets. As a result, global economies are struggling with the reality of slower growth and inflation, coupled with peaking geopolitical tension. These factors will not likely be resolved in the short term. However, the result may be one of the most intriguing bottoming-out phases in frontier and emerging markets.
S&P Global Ratings recently lowered its growth projections for emerging markets to 4.2% in 2022, a far cry from the previous days of 2007-2008 when China was growing at double-digit rates and other countries such as India and Russia were growing at 8-9% per year. While emerging markets have historically been a play on commodity demand growth, this generalization does not currently hold for multiple reasons.
Commodity-importing countries will struggle in the same manner they did during 2009-2012.
In fact, the struggle may be greater due to lower growth trends, as emerging markets grew by 4.1% between 2011-2020. Many emerging economies are at the risk of entering a recession or have already entered a recession. Most of Asia’s emerging and developed economies are net importers# of oil, gas, and metals, which is one of many reasons Asian economies thrived after 2014, when commodity prices bottomed out. However, much greater risks can be seen in regions like Africa, as it imports around 85% of its food. Trends like these can greatly harm consumer stocks, which are often the most sought-after stocks by institutional investors in these markets. Furthermore, other sectors like banking will not necessarily be able to take advantage of rising rates to prosper, as the underlying economic slowdown will increase NPLs.
Choosing to shift one’s focus to net commodity export countries is the most obvious choice, but this comes with a set of risks unique to the last commodity supercycle. Some of the top commodity-exporting countries are located in Latin America, MENA, and Africa. Countries in Latin America, such as Chile, Brazil, Colombia, and Peru, have been facing increased political risks in recent years. FDI plunged by 45% in Latin America in 2020. Political risks in Africa have also resulted in certain countries, such as Nigeria, not fully realizing the benefits of the commodity boom. Nigeria’s daily production of oil has recently not surpassed 1 million barrels, which is nearly 50% below its OPEC quota. As a result, the government did not have enough revenue to service its debt in August. While MENA may be a clear victor, these countries already trade at relatively lofty valuations. Saudi Arabia trades at over 17x earnings, Kuwait at 23x earnings, and Bahrain at 13x earnings. It is very difficult to exploit this growth trend in the equity markets unless you are willing to pay a higher valuation or navigate choppy political waters. South America is an interest high-risk value investing destination, as many markets are trading at single digital PE ratios. Equities in markets like Brazil currently seem to be priced for the worst on the back of the country’s upcoming elections. In short, one has to accept a higher valuation with lower political risks or a lower valuation with significant political risks.
Emerging markets will likely grow at a much faster rate than developed markets, but this alone is not enough for equity valuation to move in line with or above the valuation of global equity markets. The inherent political risks in these countries are greater, and countries are struggling with other issues like inflation, slower growth, and increasing sovereign debt. Furthermore, growth narratives in the past have hinged upon boosting trade as a % of GDP and exploiting export markets in the United States and Europe. This fact may complicate the relative outperformance narrative moving forward, as the global growth outlook is not very favorable. Country-specific narratives will emerge in this space, as some countries may be able to capture export market share in more advanced areas, like electronics and semiconductors.
Political Risks: Energy and Global Hegemony
The Arab Spring conflicts in 2011 serve as an appropriate benchmark of how food and energy inflation can exacerbate political risks. One does not need to look hard to see other recent examples that have taken place in countries since 2019. Rising metro fares in Chile, rising food and energy prices in Turkey, rising energy prices in Sri Lanka, and rising energy prices in Pakistan all led to major political protests, which have relegated the potential of the country’s respective equity markets. The final three countries struggled as net importers of food and oil. However, what is more crucial to note is that many emerging markets that are not exporters of crucial commodities have not been able to exploit higher commodity prices to benefit economically. Select key commodity exporters, such as Peru, Colombia and Brazil, have faced heightened political and economic risks in recent years, including rising inflation. The relatively favorable growth experienced by some of these countries has not been able to offset the issues of high food and energy inflation in countries where citizens spend a large % of their income on food and energy.
As a result, it is hard to bet on emerging markets now, as their future success seems to hinge on a reduction in commodity prices and healthy conditions in developed markets, which seems out of the question due to this year’s food and energy supply side challenges. There are exceptions, such as countries that can move up the export value chain or commodity-exporting countries that overcome political setbacks. Chile and Vietnam may be two exceptions within the emerging markets space. Chile is well positioned to benefit from the growth in copper demand due to EVs, solar energy, and wind energy, given that it accounts for 28% of global copper production. Vietnam may achieve another major value chain hop by moving into semiconductor manufacturing in the coming years.
The other thorn for emerging markets is the rising tension between the United States and other dominant global countries such as China and Russia. Recent events in Russia have easily had a disproportionate impact on the frontier and smaller emerging markets that are vulnerable to food and energy prices as they import these products. Geopolitical tensions will likely translate into shifting trade trends as Russia and China begin to trade more with other Asian countries. Southeast Asian countries have been increasingly trading with the United States, as all 10 Southeast Asia countries increased trade with the United States between 2013-2018. However, regions such as MENA and Central Asia will likely receive increased interest from countries like Russia and China as geopolitical tensions rise, as both regions are key producers of oil and other clean energy technologies. Central Asia countries are well positioned to geopolitically exploit relationships with China and Russia and perhaps develop an economic uprising trend akin to Southeast Asia’s development in the past. The region does have the ability to develop other industries, such as textiles and ICT, in order to diversify away from resource and agrarian-based growth.
Conflicts between China and Taiwan presents conflicts on multiple fronts, relating to geopolitical factors, macroeconomic factors, and equity valuation. China is Taiwan’s largest trade partner, which is one-factor holding back political escalations. At the same time, the United State’s role in this conflict is unclear, but a more proactive role would likely result in a mutual round of sanctions. Using Russia as a pretext, it is clear that European countries could follow suit, resulting in even more supply chain disruptions. A political event like this would have a negative impact on equity markets. However, it is imperative to note that China and Taiwan collectively account for 47% of MSCI Emerging Markets. As a result, even emerging equity markets with favorable narratives would likely not perform well due to broader emerging market turmoil.
Sovereign Debt and Lessons from the 1960-the 70s
Investors tend to try to extrapolate the past when looking for the next economic black swan. But the reality unlikely occurs in unseen areas, this time from the 1970s. There were only a handful of historical benchmarks of previous significant SARs outbreaks, in 1918, 1957, and 1968, for one to draw a comparison. This is not to mention that the supply chains of today were night and day different from back then.
In this decade, one of the last things on investors’ minds was a sovereign default risk. After all, only Russia had ever done so, and this was back in the early 1990s. This is not to mention that it is theoretically impossible to default on sovereign debt and that a country merely chooses not to print more money and debase its currency. However, recent sovereign defaults in Sri Lanka and Russia may give emerging market investors a taste of what is to come. The average public debt in emerging markets rose from 52% before Covid to a historical high of 67% in 2021. Vulnerable frontier and emerging markets are struggling with increased external debt levels, and have had to struggle to pay higher interest costs at a time when government revenue was struggling. The Eurobond market, which provided over $40 billion in loans to Africa over the past decade, is a new thorn, as the interest rate in markets like Nigeria currently exceeds 12%. A wave of defaults and the subsequent normalization of sovereign debt defaults is an approaching risk that has not been discussed enough.
It is difficult to use the 1970s as a benchmark when examining emerging market equities, even though some macroeconomic elements are similar. Many emerging market stock exchanges were launched during or after this period and had extremely different macroeconomic states. Furthermore, Asian economies have improved substantially since the Asian Financial Crisis and overall global emerging markets are now running a current account surplus. The safest approach to navigating emerging markets would be to focus on key macroeconomic indicators like twin deficits, economic growth, and foreign exchange reserves while determining if the current political environment is acceptable.
It is harder to predict how emerging market equities will react to a long-term stagflationary environment. The period following 2008 is one of the best examples, although this period is different because the commodity boom was driven by China’s economic growth, not supply disruptions, and reduced capital expenditure in key energy sectors. This lack of clarity, coupled with a potential plunge in foreign investment in these equity markets, may create one of the most intriguing buy opportunities within frontier and emerging market equities, some of which are already attractively priced.
Demographic, FDI, and Value Chain Transitions
It is clear that much of the emerging market economic growth and subsequent boom of the capital markets is attributable to the increased role of trade in generating long-term growth. For example, trade as a % of GDP in East Asia rose from 22% of GDP in 1972 to 69% of GDP in 2018. For example, countries like Vietnam diversified their export structure by reducing crude oil exports as a % of total exports from 17% in 2008 to 1% in 2016. Furthermore, phone and spare parts exports rose from 0% to 20% of total exports during the same period, while computers and electronics rose from 4% to 10% of total exports during the same period. Smaller frontier markets have the opportunity to follow suit by shifting away from commodity exports to textile and electronics exports. The nature of FDI will likely make or break many frontier and emerging markets. A plunge in FDI is certainly devastating for emerging markets; what is also concerning is the lack of technological spillover of FDI and the tendency of FDI to sometimes target lower-end industries. FDI should target higher-end industries, and ideally, countries should introduce new technologies, as demonstrated by countries like Japan that offer more valuable FDI.
However, it will be difficult for others to follow Asia’s example and less ideal to do so at a time when a global recession is approaching. Africa is in a sweet spot in terms of its demographics but has lots of work to do to follow East Asia’s path. This transition would entail exploiting trade relationships with regional peers such as Europe and the Middle East and finding a convenient way to import lower-cost components. Manufacturing in Africa increased by 3.5% during 2005-2014, which was well ahead of the global average. However, the key issue is not the growth of manufacturing in Africa but rather the ability to manufacture lower-end products at export-level quality and then begin climbing up the value chain to export products like electronics. This is a difficult leap that many Southeast Asian countries, which benefit from proximity to South Korea and Japan, have not even taken. This is one of several reasons why African equities will likely trade at a steep discount to Southeast Asian equities this decade.
Demographics are also one of the most important considerations when choosing an emerging market narrative to invest in. Asia is poised to cash in on demographic dividend, though at possibly poor timing. Asia alone accounts for 60% of the world’s total population, and the median age in Asia is 32. This bodes well for domestically operated consumer stocks in this region, as well as exporters that can manufacture products for South Korea and other economies that are exporting lower-end manufacturing activities.
However, countries with less favorable demographics also have more innovative, service-based economies, and these markets should not be overlooked. A demographic-obsessed approach has led some investors to overlook markets such as South Korea, which trades at a discount to MSCI Emerging Markets despite its higher level of economic innovation and technological capabilities.
Making Regional Bets in Emerging Markets
Emerging markets are due for a bull run once issues related to commodities and politics are resolved. Now more than ever, it appears that there will be a significant divergence in performance between countries based on commodity exposure and value chain positioning. Furthermore, some markets like Pakistan and Egypt could still outperform based on their compelling valuation, even though food and energy inflation will harm these countries until inflation wears off.
The stock market cap to GDP ratio is one metric used to determine whether stock markets are being overlooked and could receive further attention in the future. The ratio is 20% or lower in markets such as Romania, Pakistan, Egypt, Kenya, Uzbekistan, Bangladesh, and Kazakhstan. All of these markets also trade at single-digit PE ratios.
Making regional bets is another sure way to outperform in the long run. Pricing inefficiencies are present due to perceived risks being greater than actual risks, resulting in clear value plays. At the same time, certain markets may have a clear investment narrative, a more stable political situation, and superior economic standing but also trade at a premium to the MSCI frontier and emerging markets index.
Latin American equities are trading at a massive discount to MSCI frontier and emerging markets, and many are also key beneficiaries of recent commodity price movements. Another key but less discussed advantage for Latin American economies is their ability to increase trade with countries like Canada and the United States, which may want to diversify their supply chains away from Asia for some products. According to the ADB, the Latin American and Caribbean economies can add around $78 billion in exports by nearshoring and could benefit in areas such as the automotive, textile, pharmaceutical, and renewable energy industries.
Southeast Asia arguably has one of the clearest growth narratives, underpinned by favorable demographics, as well as strong and stable export-oriented growth that will be hard for competing regions such as Africa to capture. Although many of these countries are net commodity importers, global electronics demand growth is in a way an inflation hedge as electronics prices can rise. The electronics sector accounts for 20-50% of total exports for most countries in this region. Textiles are also a huge export for many countries in the region, which is a double-edged sword for many countries. Countries may benefit from rising textile demands and pricing power, but material importers may struggle as input costs increase. This decade is an ideal moment for frontier and emerging Asian markets to cash in on their demographic dividend, though the timing is somewhat unfortunate as a recession in the United States, China, and Europe could deter its export-oriented growth model. Therefore, countries that can diversify their export mix and move up to more technical exports are more likely to succeed this decade.
Many narratives in Asia focus on demographic and export-oriented growth, but another source of superior returns could be found in highly innovative countries with poor demographics. South Korea is an obvious fit for this type of narrative, as it was the first country to roll out a nationwide 5G network in 2019, and it recently jumped from 10th place to 5th place in the Global Innovation Index this year. South Korea has the freedom to export lower-end manufacturing activities, like the assembly of electronics in Vietnam, to focus on more innovative measures. This transition will bode well for both the economy and the stock market, which still trades at a 32% discount to emerging markets.
Africa’s transition to a higher export-oriented manufacturing economy with export-oriented growth will take a long time, although its trade-to-GDP ratio is relatively high at 50% as of 2020. Many of the economic reform policies in China, South Asia, and other Southeast Asian countries began in the 1970s-1980s and took decades to produce meaningful results. Subsaharan Africa does have a long-term shot at a similar transition, which can be exploited by the country’s favorable demographics, as the region’s median age is 20. However, higher commodity prices will hurt the region in general, and the country’s largest oil producer, Nigeria, is still struggling to meet OPEC oil production quotas and pay the interest on its sovereign debt.
Although MENA and Central Asia are two distinct geographic regions, they share two common characteristics. Both regions benefit from an increase in commodity prices, which can serve as a catalyst to boost other sectors, and both regions are strong geopolitical targets for superpowers such as China and Russia.
Central Asia is often overlooked for its resource capabilities, although the region ranks high in proven reserves. The region holds 38.6% of global manganese reserves, 30% of chromium reserves, 20% of lead reserves, 8.7% of titanium reserves, 5.3% of copper reserves, 5.3% of cobalt reserves, and 5.2% of molybdenum reserves. Many of these minerals are essential in the transition to clean energy, yet it is rare for Central Asia’s significance in this transition to be discussed. The region is also full of other promising industries, such as textiles, favorable demographics, and an improving economic and political landscape. The Uzbekistan government implemented reforms in 2019 designed to help boost the economy. Although the capital markets are less mature in terms of total market cap and liquidity, relative to frontier Asia and even Africa, there are still promising long-term prospects in this region for those interested in the capital markets of Central Asia.
The Middle East and North Africa region hold 57% of the world’s proven oil reserves and 41% of the world’s natural gas reserves. This fact has allowed countries in the region to benefit during 2022, while other regions that traditionally had higher growth failed to outperform MENA economies. The World Bank projects that the region will grow by 5.2%, the fastest growth the region has experienced since 2016. This growth rate is also on par with the growth rate projected for the ASEAN 10 countries.
The Next Decade
Commodity price gyrations and political black swan events will shape frontier and emerging equity markets during the next few years. Oddly, these events may serve as much-needed forces to help create truly attractive entry points for various frontier and emerging stock markets. Rather than betting on commodity price movements and key beneficiaries, it makes sense to focus on other long-term factors such as demographics, innovation, and manufacturing capabilities, especially since equity markets are more likely to overlook these factors and focus on politics and commodity price movements. 2022-2023 are the best years to selectively shop for attractive narratives, as normalization in commodity prices and geopolitical tensions is necessary in order to adopt a holistic bullish view of emerging market equities. If equity valuations move towards Post 2008 levels, then emerging market equities could be one of the most attractive buys of this decade by 2024 or later.
Sources
Bambaci, Juliana, et al. “Built to Last: Two Decades of Wisdom on Emerging Markets Allocations.” MSCI, October 2012, https://www.msci.com/documents/10199/7fc700a7-3216-457a-88da-f50e71d8a15e.
Panday, Satyam, and Elijah Oliveros-Rosen. “Economic Outlook Emerging Markets Q3 2022: Testing Times Ahead For Emerging Market Resilience.” S&P Global, 27 June 2022, https://www.spglobal.com/ratings/en/research/articles/220627-economic-research-economic-outlook-emerging-markets-q3-2022-testing-times-ahead-for-emerging-market-resilie-12422225.
Callen, Tim. “IMF Survey: Emerging Markets Main Engine of Growth.” International Monetary Fund, 17 October 2007, https://www.imf.org/en/News/Articles/2015/09/28/04/53/sonum1017a.
Harting, Morgan. “Looking Back and Ahead: Eventful Decades for Emerging Markets.” AllianceBernstein, 16 July 2021, https://www.alliancebernstein.com/library/looking-back-and-ahead-eventful-decades-for-emerging-markets.htm.
Wolf, Anne, et al. “Asia Growth Slows on Commodities, Covid and Rising Interest Rates.” International Monetary Fund, 25 April 2022, https://www.imf.org/en/Blogs/Articles/2022/04/25/blog-asia-growth-slows-on-commodities-covid-and-rising-interest-rates.
Seleshie, Loza. “What’s behind Africa’s skyrocketing imports yet increased production growth?” The Africa Report.com, 2 September 2021, https://www.theafricareport.com/123719/whats-behind-africas-skyrocketing-imports-yet-increased-production-growth/.
Dehn, Jan. “Five stylised facts about EM and commodities.” Ashmore Group, April 2018, https://www.ashmoregroup.com/sites/default/files/article-docs/EV_Apr_18_Five_Stylised_Facts_About_EM_and_commodities.pdf.
“Foreign direct investment in Latin America plunges by 45% amid pandemic.” UNCTAD, 21 June 2021, https://unctad.org/news/foreign-direct-investment-latin-america-plunges-45-amid-pandemic.
Okonkwo, Omono. “OPEC says Nigeria’s oil production averaged 972000 bpd in August 2022.” Nairametrics, 13 September 2022, https://nairametrics.com/2022/09/13/opec-says-nigerias-oil-production-averaged-972000-bpd-in-august-2022/.
“Chile – Mining.” International Trade Administration, 25 January 2022, https://www.trade.gov/country-commercial-guides/chile-mining.
“Vietnam chip sector will be worth $6.16B by 2024.” Sourcengine, 28 September 2021, https://www.sourcengine.com/blog/vietnamese-semiconductor-industry-6-16b-2024.
Cook, Malcolm. “US-Southeast Asia Trade is Increasing, but so are Deficits.” East-West Center, 16 October 2019, https://www.eastwestcenter.org/publications/us-southeast-asia-trade-increasing-so-are-deficits.
“MSCI Emerging Markets Index (USD).” MSCI, 31 August 2022, https://www.msci.com/documents/10199/c0db0a48-01f2-4ba9-ad01-226fd5678111.
Goldstein, Jeff. “Trouble for Emerging Markets could spell trouble for all.” Atlantic Council, 29 June 2022, https://www.atlanticcouncil.org/blogs/econographics/trouble-for-emerging-markets-could-spell-trouble-for-all/.
“African Nations May Have Saved $30 Billion by Avoiding Eurobonds.” Bloomberg, 5 December 2018, https://www.bloomberg.com/news/articles/2022-08-02/african-nations-may-have-saved-30-billion-by-avoiding-eurobonds/.
Wheatley, Jonathan. “Emerging markets: all risk and few rewards?” Financial Times, 14 February 2022, https://www.ft.com/content/9cc2826b-dcd2-49c5-a408-7de043d24a79.
“Trade (% of GDP) – East Asia & Pacific | Data.” World Bank Data, https://data.worldbank.org/indicator/NE.TRD.GNFS.ZS?locations=Z4.
“Vietnam: Tail of the Dragon.” Mirae Asset Financial Group-Main, 2018, http://www.miraeasset.com/upload/insights/recent-insights/Mirae_Asset_Vietnam_-_Tail_of_the_Dragon_201804.pdf.
Willem, Dirk. “Why African manufacturing is doing better than you think.” ODI, https://odi.org/en/insights/why-african-manufacturing-is-doing-better-than-you-think/.
Bachelet, Pablo, and Taos Turner. “Nearshoring can add annual $78 bln in exports from Latin America and Caribbean | IADB.” Inter-American Development Bank, 7 June 2022, https://www.iadb.org/en/news/nearshoring-can-add-annual-78-bln-exports-latin-america-and-caribbean.
“Electronics.” ASEAN Investment, https://investasean.asean.org/index.php/page/view/electronics.
Kim, Byungwook. “Analysis: South Korea’s high-speed 5G mobile revolution gives way to evolution.” Reuters, 13 May 2022, https://www.reuters.com/business/media-telecom/skoreas-high-speed-5g-mobile-revolution-gives-way-evolution-2022-05-13/.
SHIRAISHI, TOGO, et al. “South Korea cracks world’s top 5 innovators while China edges Japan.” Nikkei Asia, 21 September 2021, https://asia.nikkei.com/Business/Technology/South-Korea-cracks-world-s-top-5-innovators-while-China-edges-Japan.
“MSCI Korea Index (USD).” MSCI, 31 August 2022, https://www.msci.com/documents/10199/e8fc2a89-b809-4088-a807-4b9d9ec04abc.
Valuchuk, Roman, and Indra Overland. “Central Asia is a missing link in analyses of critical materials for the global clean energy transition.” Science Direct, 17 December 2021, https://www.sciencedirect.com/science/article/pii/S2590332221006606.
“Middle East and North Africa – Energy in MENA.” World Bank, https://web.worldbank.org/archive/website01418/WEB/0__CO-46.HTM.
“MENA Economic Update: Reality Check: Forecasting Growth in the Middle East and North Africa in Times of Uncertainty.” World Bank, 14 April 2022, https://www.worldbank.org/en/region/mena/publication/mena-economic-update-forecasting-growth-in-the-middle-east-and-north-africa-in-times-of-uncertainty.
“Economic Outlook for Southeast Asia, China and India 2022.” OECD, https://www.oecd-ilibrary.org/sites/f4fab965-en/.