Emerging markets… it ain’t growth

The common mantra we hear quite frequently is that investors need to be invested in emerging markets because that’s where the growth is (“emerging middle class”, “growing population”, “emerging consumer”, “sclerotic hopeless developed countries”, “technology take-up” etc.). Sounds pretty reasonable on the surface, so let’s take a look at the responsiveness of absolute and relative emerging market equity returns to absolute and relative GDP growth. If growth matters it should be pretty self-evident in the data.

The first chart shows emerging market local currency equity index returns plotted against nominal GDP growth.

There appears to be no relationship here at all – the R-squared coefficient is zero (for the statistically-minded that means that none of the variance in EME (emerging market equity) returns is explained by emerging market GDP growth. And, yes, there can be alpha with no correlation).


Ah, but perhaps there is a lag, so let’s look at EME returns with a one-year lag to GDP growth.


Again, nothing.

Thomas Huxley’s wonderful quote comes to mind “The great tragedy of Science – the slaying of a beautiful hypothesis by an ugly fact”.

Looks like the variability of EME returns are not well explained by GDP growth at all.

What if we look at the relative performance of EME vs world equities against the relative GDP growth of developing and advanced countries?

Nothing changes. We can say pretty confidently that faster growth in the developing world versus the developed world are of no consequence for relative equity returns.


What if we get more granular and look at individual markets? The following chart looks at the growth versus returns relationship for Brazil over the last fifteen years (constrained by data limitations).

Once again, the story is familiar, it ain’t growth variability driving the Brazilian equity market.


Mix real and nominal variables (not for the purist, admittedly, but let’s do it) or impose lags and the picture doesn’t change at all.

So, the next time “emerging market equity” and “growth” appear together think hard about that relationship (or lack of, in reality).

The case for EME is far more subtle than superior growth = superior returns.

  • The dilution from equity issuance to finance the growth must be considered.
  • The source, scale and cost of capital to and from developing countries must be considered.
  • Valuation and risk premia must be considered.
  • The distribution of the returns to growth between owners of capital and agents for capital (wages, empire building, dividends) must be considered – shareholders are not the only potential beneficiaries from aggregate earnings growth.

Today, the structural unwinding of $6 trillion or more of net capital inflow into the emerging markets in the last cycles is the dominant theme, in our view, and only when that has played out fully would we be confident in investing in emerging markets (by which time valuation and momentum will, hopefully, both be enticing).



A little goes a long way

On the face of it, a 25 basis point (bp) increase in the US federal funds rate (the interest rate at which banks trade their excess reserves) looks pretty benign and inconsequential. Janet Yellen appeared to play down the consequences, but any student of economics knows that a little bit of tightening can go a long way under extreme circumstances.

Unfortunately, these are extreme circumstances and, in combination with liquidity developments outside the US, the US Fed just tightened global liquidity conditions very aggressively.

The first chart shows the relationship between the monetary base (under the control of the Fed: notes and coins + required bank reserves + excess bank reserves) and the short term interest rate.

On the vertical axis is the interest rate and on the horizontal axis something economists call the “liquidity preference”, which is simply the amount of monetary base per unit of GDP (or, in other words, how much “money” supports each dollar of gross domestic product).

  • At very low levels of interest rates the opportunity cost of holding money becomes trivial/near zero and so more money is willingly held.
  • At very high levels of interest rates the opportunity cost of holding money is very punitive so less money is willingly held.

Money moves faster around the economy (works harder) when interest rates are high and more slowly around the economy (works less hard) when interest rates are low.


Where are we now?

Well, unfortunately for the Fed, we are out at the far right of the chart with rates near 0 and liquidity preference at a record 22/23 cents per dollar of GDP.

So what?

Well, as we noted, money works harder when interest rates go up so for the Fed to actually tighten monetary policy they need to remove liquidity (“monetary base”) from the system. Otherwise, paradoxically, by raising rates they will have eased monetary policy (made money work harder).

How much liquidity do they need to remove?

Well, let’s look at the chart. A 25 bp short rate implies liquidity preference (money/GDP) about 30% below the current level, around 16 cents from 22/23 cents per dollar.

Given that excess bank reserves held at the Fed are $2.58 trillion, or 65% of the total monetary base, it would imply that the Fed needs to remove around $800 billion in liquidity from the system.

Note: the relationship between interest rates and liquidity (the size of the Fed’s balance sheet) is non-linear. In short, each successive 25 bp of tightening requires less liquidity removal; the liquidity removal is highly front-loaded (this was noted by former Fed Board member Professor Charles Plosser as far back as 2011). So, the first 25 bp is the hardest, requiring the better part of $1 trillion of liquidity removal. The next 25 bp are a further $200 billion (approximately) and so on.


Indeed, that’s a lot of liquidity taken out of the system. That must have an impact on market liquidity, asset prices and the US dollar.

However, it gets worse. Look at the drawdown in global foreign exchange reserves (essentially, capital leaving the emerging markets).


Emerging markets are losing liquidity at an almost unprecedented rate just at the point where the US Fed is likely to be taking the best part of $1 trillion out of the system – global liquidity conditions are tightening severely.

As always, we will observe and respond as/when/if the Fed follows the path.



That time of year

It’s that time of year for forecasters to rejoice in the opportunity to produce forecasts for the year ahead. Economists like Christmas – it brings the gift of a spotlight for their year ahead projections. However, when those economic growth forecasts start landing in your inbox, it might be worth keeping the following simple charts in mind.

We look here at the US market (simply because it is the heartbeat of the market overall and is so influential, but the analysis holds equally elsewhere) and the annual relationship between the growth rate of the economy and the return on the S&P 500.

Chart 1 shows the annual nominal return for the S&P 500 from 1990 onward plotted against the annual nominal rate of growth in US GDP.

Quite strikingly, there is absolutely no relationship at all between annual nominal US growth and annual nominal US equity returns (look at those coefficients, zeroes everywhere).


Let us torture the data a little to see if we can squeeze something useful from it. Chart 2 shows the annual rate of growth of real US GDP plotted against annual nominal US equity returns.

No change, still irrelevant. Where the economy goes the market does not follow.


So, with that in mind, perhaps it is time to give your economist a break this year. Not surprisingly, we will not be winging our economic growth forecasts to your inbox.

It’s not the economy, stupid.

P.S. Here is the same chart for the UK.