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).



China’s threat in two charts

If, in fact, China is growing at the reported 7% target rate, it certainly is not evident in these charts.

Things which are produced have to be moved to market. The first chart shows Chinese Rail Freight Volumes (% year/year).


The second chart shows the Volume of Freight per Kilometre Travelled.


Rail freight in China is falling at the fastest rate (year/year) in over twenty-five years.

This certainly does not look like an economy hitting its targets and running at an enviable (even within emerging markets) 7% growth rate.

It looks like an economy that has slowed alarmingly since the second half of 2014. In fact, it looks like an economy going off the rails (excuse the pun).



Structural headwinds for Emerging Markets

August 26, 2015

A common misbelief among investors is that economic growth and equity market returns are positively correlated. Faster growing economies generate faster earnings growth and that must be good for investors… right? Wrong.

It ignores 3 important factors (1) companies typically issue large amounts of new equity to finance the growth such that earnings per share growth (not earnings growth) suffers badly (2) the benefits of company growth can accrue to three alternative agents: investors, managers and/or employees. Often, once managers have paid themselves, employees have received pay rises and the company goes on an investment spree, there is little or nothing left for the poor old investor standing patiently at the back of the line and (3) investors often overestimate growth and overestimate the durability of growth, extrapolating rapid growth into the horizon when we know that mean reversion is an important feature of all economic activity.

Nevertheless, for as long as investors suffer the cognitive dissonance of believing in growth miracles (China has been the best, delivering miserable returns to “apparently” rampant economic growth over the last two decades) it is important to look at the structural underpinnings of Emerging Market growth.

Two simple charts illustrate the huge structural headwinds facing Emerging Markets in the next five years or more that will, over the course of the cycle, overwhelm any benefit that might accrue from near term currency devaluation:

  • Firstly, we can see that the “Growth Gap” between Emerging and Developed Countries is very highly correlated with the scale of deficits run in the Developed World. The rapid acceleration of EM growth versus the West in the period 2000 – 2008 (that gave rise to endless stories about the sclerotic Developed World giving way to China and Emerging Economies, that Emerging Economies would dominate economically and politically within a few years, that investors need only follow the path to the East to find riches) was driven purely and simply by unprecedented Developed Country deficits.
  • The EM growth boom was “Made in the Developed World”


  • Secondly, this ballooning Western deficit promised eternal reward and investment surged in the Emerging Markets to build capacity to meet the promise of endless demand:
    • Investment as a % of GDP in the Emerging World exploded from 25% to 31% in just about a decade.


    • Sadly, just as investment reached levels unprecedented in the last century, demand evaporated as the Developed World deficits evaporated (a $650 billion swing since 2008).


  • This means Emerging Markets have been left out on a limb – unprecedented investment with no apparent demand… Mind the Gap.


What does it mean?

  • Investment/GDP ratios in the Emerging Markets must fall sharply in the next 5 – 10 years, back to levels prevailing prior to the run up after 2000. That means much slower growth structurally. To think that the fabled “Emerging Consumer” can step in is without justification.
  • The disappearance of the Developed Country deficits means a disappearance of US Dollars and that implies tighter conditions domestically, compounding the adjustment in investment. In other words, the growth rate in International Foreign Exchange Reserves (the counterpart on the Central Bank balance sheet to the growth in domestic currency liquidity) will slow rapidly and in due course, as in China, reserves will flow away rapidly. Rising reserves imply easier domestic policy conditions, falling reserves imply tighter domestic policy conditions.
  • Weaker currencies and, in some cases, lower interest rates can cushion the blow but the headwinds are far too strong to be resisted domestically. Emerging Market growth will go back to levels little different from the Developed Countries, as was the case prior to 2000. If “growth is your thing” that’s not an appealing prospect.
  • Having been out of EM Equities for the last two years we would not anticipate re-entering anytime soon.



Asian borrowers in trouble

March 13, 2015

With the US dollar trading close to a 12-year high, over-leveraged Emerging Market currencies look very vulnerable. This is because Emerging Market financial assets (read debt levels) have approximately doubled since 2008. Asian countries in particular have pilled foreign debt at an accelerating pace with the year-on-year debt growth for the Asian block now reaching 35%.

From the perspective of an Asian investor, leverage makes sense. Borrowing large amounts of money in a depreciating currency means less capital to pay back at maturity. And low interest rates (US rates have been close to zero for 6 years) make for negligible interest payments. Asian countries have gorged on this bonanza and the jury is out as to whether this is going to result in a painful indigestion.

The moment of truth might be near. The US dollar is powering ahead as the US Federal Reserve (the “Fed”) has indicated that its next monetary policy move will be restrictive, not accommodative. The Fed is remarkably lonely here as 9 countries have lowered their main interest rate since the beginning of the year already.  Yesterday again, the Korean Central Bank reduced its key rate to a historical low of 1.75% and the Chinese are considering a similar move. With comparatively fewer dollars and more of other currencies in the system, the value of the greenback has to go up.  This is exactly what is happening, and this is happening quick- the USD trades 10% higher than at the end of 2014.

At MONOGRAM we are staying away from Emerging Market stocks, since a forced de-leveraging caused by a strong dollar will certainly translate into substantial downside in domestic equities. But should the going get tough, these assets will probably trade low enough to present a bargain. Until then, we prefer the safety of the US market.