Emerging market performance was traditionally viewed in part as a function of US interest rates. This has happened for two reasons. If US rates are low, investors take more risk. As the yields available on cash, government bonds and safe-haven equities in their own markets become less attractive, they search for higher yields in higher-risk areas such as emerging markets.
Economic theory also suggests that low interest rates should be positive for global economic growth. This is particularly beneficial from an emerging market perspective: it improves liquidity, and the commodity prices that underpin many developing economies tend to move higher in such scenarios.
Thus, according to conventional market logic, the gradual increases in US – and more recently UK – interest rates should mean emerging markets start to underperform.
As rates rise, so do the yields on lower-risk assets such as government bonds, meaning there is less incentive to invest in emerging markets.
Higher interest rates have also been bad news for emerging markets in the past, because many corporations and countries must borrow in dollars or other developed market currencies. As rising rates push up the value of those currencies, emerging borrowers need more money than previously to repay the debt, and that leaves less free cash for investment, dividends, and so on.
Warning shot
These implications were highlighted in the winter of 2014 when investors were gripped with anxiety over US interest rates rising. Risk assets, including emerging market shares and bonds, bore the brunt of the sell-off.
Yet despite a seeming litany of headwinds, emerging market equities have been one of the stronger performing markets of 2018, gaining 0.72 per cent in the three months to the end of March – a period when the US, UK and major European markets were all in the red.
Austin Forey, a managing director at JPMorgan Asset Management, running around £2bn across a number of emerging market equity funds, believes he has the answer to this anomaly.
He notes that while US interest rates have been rising, the dollar has actually been falling. Mr Forey says the negative impact of interest rates hikes only happens when the dollar is rising.
Donald Trump’s policy of tax cuts could well ensure the dollar remains subdued, as it increases the budget deficit.
On top of this, Mr Forey adds that emerging market economies are now less reliant on short-term funding from overseas investors than was the case in the past. He says this is because of the structural changes in these economies.
Many emerging market countries now have substantial domestic savings, so debt issued in those economies can effectively be funded by the local population, rather than from overseas markets.
This contrasts with developed markets, where consumer savings ratios are much lower.
Peter Elston, chief investment officer at Seneca, considers it wise to have a permanent allocation to developing economies, because whatever the impact of the economic cycle on various developed markets, emerging markets as an asset class are likely to have a long-term structural growth rate that is higher than developed markets’.
Productivity
One way to assess these potential growth rates is to examine the level of productivity growth in an economy, and compare it with the level of population growth.
While birth rates and population growth in developed markets is stagnating, this is less of a problem in most emerging markets as they have young populations.
The relative youth of the population also contributes to enhanced productivity, as more of the population are likely to be of working age. Younger workers also have a greater propensity and flexibility to embrace the sort of technological change that boosts productivity in an economy.
Mr Forey says technological adoption is much higher in emerging markets as those economies have, in many cases, “skipped a generation” from the old economy to the new.
He says: “Look at an area like telecoms. People went straight to owning mobiles, because there was never the infrastructure there in the first place for more traditional fixed-line telecoms. This has led to mobile payments being very widely used in emerging markets, and mobile banking generally, as traditional banking networks did not always exist.”
Fewer people using obsolete technology means a boost to productivity, as each worker can get more done using the most modern methods.
The relative lack of employees and capital dedicated to inefficient industries can also boost productivity in emerging markets compared with developed markets. In the latter, legacy industries – many of them state-owned or politically powerful – continue to operate and drag down overall levels of productivity and, in time, economic growth.
Of course, emerging market countries are hardly strangers to the concept of inefficient state-owned industries.
But Anthony Rayner, a multi-asset fund manager at Miton Group, notes that many Chinese companies are ahead of their western rivals in areas such as electric car technology, and have government sympathy and support for their initiatives, while allegiance to older, legacy, industries remains strong among policymakers in developed markets.
Simon Edelsten, who runs the £170m Mid Wynd International investment trust, says such trends are most acute in India at present, where the government is also instigating a programme of business-friendly economic reforms.
China remains the emerging market economy that prompts the most conversation. However, many of the trends associated with emerging market growth, notably population increases, are less relevant in this case.
This is because of the one-child policy implemented in China for many years. While the country does embrace technology in a way that is typical of, or superior to, other emerging markets, the previous economic model pursued by its government – which centred on capital investment – created a swathe of projects that did not make the most efficient use of capital.
Protectionism
If the emerging markets have generally been able to withstand the tighter monetary policy of the US Federal Reserve in recent years, the next challenge will come from protectionism.
Talk of a trade war is on the increase again now that the US has opted to impose tariffs on China. The seriousness of such an outcome can be illustrated by examining the impact of the Smoot-Hawley Tariff Act, a piece of legislation introduced in 1930 in the US. This act introduced a wave of tariffs on imported goods into the US.
The 1930s are remembered as a period of economic recession and stagnation around the world.
Any repeat is likely to have the greatest impact on economies that derive the greater part of their GDP from exports. This is the case for many emerging market economies, which export commodities or consumer goods to the developed world.
Policymakers in China have, since its party congress in 2013, vowed to shift the economy to a model based more on domestic consumption, and one that is less reliant on the export-led growth that has driven development in the country.
If such an approach can be successfully implemented it would help to insulate China from the impact of a global trade war, as protectionist actions would hurt the export part of the economy, rather than domestic consumption.
But if, as traditional economic theory would imply, the ultimate outcome of a trade war is stagflation – defined as high inflation and low growth – it is likely those emerging market economies that rely on exporting commodities will suffer most.
The reason is that in a world of slow growth, there is less demand for commodities, as companies are less motivated to manufacture goods they fear they will be unable to sell. This scenario remains a risk worth pondering for developing economies of all stripes.
David Thorpe is investment reporter at FTAdviser.com. Russell Taylor is away
