Investment opportunities in the recoveries of developed and emerging markets

Distinct recovery paths are emerging for developed and developing markets in the wake of the global financial crisis. Michael Hasenstab examines the opportunities for investors.

There is likely to be differentiation in how various countries recover from the global financial crisis. These factors may provide some interesting investment opportunities over the next couple of years.

In terms of understanding the differences and vulnerabilities of countries going forward, we believe it’s important to understand the key drivers that are expected to differentiate a particular country’s recovery.

On the whole, this analysis continues to point to one of the major themes in positioning portfolios — the emerging markets versus the developed markets story.

Emerging markets versus developed markets

In our view, there are five major factors that will influence the speed and strength of the different recovery paths.

Domestic economy and export sensitivity

Those countries that had a very large component of domestic demand versus a reliance on exports have been better cushioned through this crisis, and are probably better positioned for an environment where we are likely to see weaker global growth.

Countries such as China, India, Indonesia and Brazil appear to have remained pretty robust throughout this most recent global economic downturn, and seem to be on a healthier path compared to some of the economies that were more reliant upon an export engine.

Most market observers 12 months ago would have predicted that if emerging markets experienced a drop of 30 per cent in exports, domestic growth within these countries/regions would collapse in tandem.

That is because the perception was that many emerging markets were reliant upon export-driven growth models and, to varying extents, export industries have been an important driver of employment and investment in a lot of these economies.

However, what the recent global economic crisis illustrated was that export growth is not the only thing driving many emerging market economies.

Looking at the change in the composition of final demand between the third quarter of 2008 and the second quarter of 2009, we have seen a substitution from export to domestic demand of 10 percentage points.

So instead of everything getting weaker, there was a significant substitution, particularly in Asia, between the export-led economy and the domestic economy.

It also illustrated a key difference across the various countries. Some emerging countries appeared to be far more sensitive to the decline in exports, such as Singapore, Malaysia and Taiwan, whereas other emerging countries, such as China, India and Indonesia, seemed far less sensitive.

So the reliance upon external markets varies, and our analysis of emerging markets is currently favouring those economies that have strong domestic demand.

Policy responses

Many countries have had to resort to extreme stimuli measures.

Extraordinary monetary and fiscal support was provided in many places including the US, UK and China, and while these policies have played an important role in limiting the severity of the recession and may lead to an earlier recovery than would have otherwise occurred, there are likely to be longer-term costs associated with them.

While both developed and developing economies have utilised stimuli measures, in emerging markets governments are in a position to begin unwinding their policies sooner than may be possible in the developed world.

This illustrates that there is something underway in a lot of these emerging markets, more than just cheaply priced exports because of undervalued exchange rates.

There is not only a domestic consumer base that exists and provides some cushioning, but many policymakers now have a framework and transmission mechanism in place to stimulate domestic demand through their own respective monetary and fiscal policy.

There has been a structural change in several of these economies where policy has improved to the point that counter cyclical measures are now possible and can be effective.

We are already seeing evidence of this as growth has reaccelerated and output gaps are closing in many emerging markets.

Future capital flow dynamics

We believe the crisis was primarily a developed world shock, particularly stemming from the US, UK and Europe.

While there was an initial increase in risk aversion, over the medium term the crisis is likely to accelerate the structural reallocation of capital to other parts of the world.

Again, the data so far supports this. Even though China has faced a severe contraction in exports, the increase in capital flows has more than offset the negative effects of the decline in exports, resulting in higher inflows on the whole.

While the decline in exports has received much of the attention, what’s being ignored is the positive effect of huge amounts of capital coming into these countries, which in many cases can be more important.

We believe this trend is likely to continue going forward as the relatively stronger growth and higher interest rates in emerging markets attract increased capital.

The differentiation of recoveries (and consequently policy) is central here and we would expect that the liquidity created in the most severely impacted countries would likely flow to not only emerging markets but also developed economies that are in stronger positions, such as Australia and Norway.

Overhang from previous excesses: leverage and overconsumption

Financial sector deleveraging is far more prevalent in the UK, US and Eurozone than in the emerging world, which going into this recent global economic crisis did not have a tremendous amount of leverage on their respective balance sheets.

Asian banks, in particular, used significant leverage in the boom before the financial crisis in the late 1990s.

Since then, most countries within Asia have run a very low leverage ratio and, as a result, do not have the burden of an overhang which, unfortunately, may inhibit future credit extension and therefore growth in the US, Eurozone and UK.

We believe the reliance on leverage is very important and may affect the pace of recovery for various countries.

Considering this was a crisis about leverage, and that we’re now entering a world where the use of leverage is not likely to be the same as it was in the past because of prudent regulation and risk changes, those countries that do not need to deleverage are, in our view, in a better situation.

While substantial steps to repair the balance sheets of financial institutions have been taken in developed economies, we believe this process has quite a bit further to go.

Consequences of high public spending and debt

The US, Japan and many countries in Europe are running massive fiscal deficits, which are likely to be a burden for those countries going forward.

These deficits are unsustainable over the long term and are adding to already high public debt levels. These debt burdens were further increased by the public sector rescues of several private institutions.

Looking at the advanced economies versus emerging market economies, we can see a vast difference in the programs required to shore up the banking system.

In the advanced economies there were real cash outlays, whereas in the emerging markets it tended to be more liquidity provisions that can be more easily unwound if they’re no longer needed.

The International Monetary Fund (IMF) estimated that the magnitude of all this financial sector support in the advanced economies was somewhere in excess of 25 per cent of gross domestic product.

In the emerging G-20 economies, it was less than 15 per cent, and over 90 per cent of that was simply a liquidity provision. In the advanced economies, there was a lot of purchasing of assets, capital injection and upfront government financing, which didn’t really occur in emerging economies.

According to the IMF in its recent October ’09 outlook, advanced economies are running roughly an 80 per cent public debt-to-GDP ratio, whereas emerging and developing economies are a little under 40 per cent.

It projects this gap to continue to expand as the massive increase in debt in the US, Japan and much of Europe contrasts sharply with more or less constant public debt levels in developing and emerging economies, which are actually projected to decline over the next four to five years.

We believe that these five major factors will go a long way to explaining the different paths of the various economies around the world during the recovery phase. In fact, the evidence of the relative strength of the recovery in emerging markets is already clear in several recent trends.

Trends in the recovery

Capital flows

We have seen capital flows dramatically increasing to emerging economies.

They’re clearly not back to the levels that they were in 2007 and 2008, but if we look at equity, syndicated loans and international bond issuance at the end of the second quarter, we’re certainly back to the type of levels we saw in early 2006 and late 2005.

And anyone observing the market these days can witness the oversubscription of new deals, which is not uncommon.

Credit

Credit has not begun to expand strongly but has been growing in emerging markets despite significant differentiation among regions.

In Eastern Europe, private credit has been contracting, but looking at Latin America, private credit growth recently turned positive after contracting earlier this year.

Emerging Asia actually never had a private credit growth contraction, looking at an annualised change in three-month moving averages, and has remained positive during the entire crisis.

Pace/change in employment

This is a very good indicator of where an economy stands on the recovery path.

Employment growth is a lagging indicator, but looking at emerging economies shows that they are actually already in net job creation, whereas in advanced economies, job losses are slowing, but significantly more jobs are still being lost than created.

While improved corporate profitability and likely profit growth could begin to reverse that trend over the course of the coming quarters, emerging economies are clearly well ahead in terms of the path to a sustainable recovery.

Economic activity indicators

Looking at any number of other indicators — private mortgage insurance data, industrial production, retail sales — economic activity growth rates in emerging economies, particularly Asia, have already recovered to the levels we saw pre-crisis.

Clearly, the actual levels are not back to pre-crisis levels, but the growth rates are, whereas the advanced economies have turned positive on some of those indicators, but are clearly nowhere near the growth levels they were at going into the crisis.

We believe that the net effect of this is likely to be continued outperformance of emerging market growth rates versus developed market growth rates for the foreseeable future.

China’s economic and political power grows

The continued economic performance is contributing to the rise of China’s economic and political power. China is clearly on a path to take on a greater role in the world economy, and this crisis sped up that transition.

We’ve seen an increased move towards the internationalisation of the yuan and an increased role for China as a political participant in global organisations, such as the IMF.

Asian policymakers

In Asia, we’ve seen a structural shift away from policymakers focused on an export model, which is somewhat consistent with a weak exchange rate, to a domestic growth model wanting to move away from the sensitivity and reliance upon the US consumer and external markets.

That shift towards a domestically driven economy is more consistent with a stronger exchange rate, which helps the wealth transfer to domestic consumers.

Brazil: net creditor

Improving economic performance has not been limited to Asia. For example, Brazil has rebounded quite strongly from the crisis.

In fact, Brazil is now a net creditor to the IMF as of October 5, 2009; so not only is Brazil getting the Olympics in 2016, it’s also reversed its role vis-à-vis the IMF, which has provided support to Brazil in the past.

Interest rates

We believe emerging market economies are likely to see higher interest rates because they weren’t levered and had more domestic growth drivers, which would feed back through to exchange rates.

Consequently, we’ve generally been cutting our interest rate exposure in a number of emerging markets and moving shorter on the yield curve to stand a bit more defensively on interest rates while still positioning to take advantage of exchange rate opportunities.

However, we still think there are a number of cases where the declining risk premium in emerging markets will actually shift yields lower structurally.

Even though a central bank may have to tighten and raise rates in a place like Indonesia, we believe significant rate hikes are already priced in.

Further, Indonesia is undergoing a big structural transformation where we think the risk premium will likely be lower.

As a result, we think government bond yields could actually stay where they are or move lower, even in the face of some moderate interest rate hikes later this year or early next year.

Michael Hasenstab is a portfolio manager and co-director of international bonds, Franklin Templeton Fixed Income Group.