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.