Suddenly, everyone is bearish…
Less than a year ago, in April 2013, the IMF forecast accelerating global economic growth driven by the resurgence of the emerging markets. How things have changed: concerns over economic health and political stability in the emerging markets have reached new heights in recent weeks, leading to falls in currencies and stock markets. Rather than the BRICs being talked about as the source of rapid growth, terms such as the “Fragile Five” are now being used to highlight the challenges facing the emergers.
Policy makers have moved to calm investor nerves: Turkey increased its main interest rate by 425 basis points overnight and India and South Africa both moved quickly to raise their rates. These and other initiatives appear to have stabilised the situation in most cases but they are likely to hit economic growth in the short term, a further blow to confidence after disappointingly weak growth in many emerging economies in 2013.
…but this has always been a long term story…
With hindsight, it is obvious that investment in the emerging markets reached unsustainable levels in the period prior to the financial crisis of 2008. As a group, the emerging markets were growing extremely quickly, China and India both at double digits, and investors may have lost sight of the economic fundamentals and made decisions on the basis on unrealistic expectations.
Financial investors have clearly changed their perspective, according to the Financial Times one third of fund managers are now underweight in emerging markets, compared to over half being overweight 5 years ago. It is harder for corporates that invest in physical assets and businesses to change their investment strategies quickly, but how should they respond?
The long term growth fundamentals for the emerging markets remain strong. The future pace of growth will be slower than between 2005 and 2008, but the emerging markets will continue to grow their share of global GDP over time. As the recent EY Rapid Growth Market Forecast identifies, population growth, urbanisation, infrastructure provision and technological innovation will combine to create rates of economic growth than will outpace those of the developed markets. However, it is also clear that performance will vary widely between emerging markets and also across sectors within individual markets. Investors have tended to view emerging markets as a single opportunity, when in fact there are a range of very distinct markets. In future, investment strategies must differentiate between opportunities on the basis of rigorous and detailed analysis. Betting on the average will not be a winning strategy.
…based on relatively fast income growth and changes in demand…
Incomes in the emerging market economies continue to grow, changing the level and structure of demand for goods and services and hence creating new opportunities. The EY Rapid Growth Markets Forecast predicts that China will have 80 million households with an annual income in excess of US$35,000 by 2022. Similar developments are expected elsewhere: Brazil and Russia will both have more than 15 million households with this level of income and Mexico, Turkey and India will each have over 10 million households.
This increased wealth will significantly change the profile of demand. The main beneficiaries of the growth in emerging markets over the last decade or so have been commodity suppliers and manufacturers of intermediate goods, such as Brazil, Australia and Germany. The consumer success stories are more recent and are at the high end with luxury goods providers and prestige car manufacturers featuring very prominently. As consumers become richer so their priorities and tastes change opening up new market opportunities.
We are now moving to a period that will see the mass consumer market develop as rising incomes lead to shifts in consumer demand. Food and staples such as energy will fall as a share of average income: EY forecasts that spending on communications, culture and recreation will grow on average at twice the rate of spending on food over the next decade across the emerging markets. Consumers will allocate resources in different ways: the share of households earning over $10,000 a year has increased from 28% to 40% in Thailand in the last decade and this has led to a doubling of the rate of refrigerator sales. We will begin to see people looking to improve their lifestyle and sense of wellbeing and security by moving from a focus on spending on basics to buying a wider range of goods and services
The sectors that should benefit from these trends include:
- Mid-income consumer products as opposed to luxury goods ;
- Health and education;
- Financial services;
- Communications and technology;
- Transport especially motor vehicles for the mass market.
It is also likely that “green” products and services will be more in demand. Rapid growth brings its own challenges to the environment such as pollution and congestion and as people become better off so they tend to be more concerned about the environment and the quality of life in a broad sense. For example, motor vehicle numbers in Indonesia increased from 10 million to 90 million between 2001 and 2011 but road kilometres only grew by 25%. Inevitably pollution and congestion have increased in urban areas and the experience elsewhere suggests consumers will look for solutions to these problems.
…however, creating value will be neither easy nor guaranteed.
EY’s analysis of consumer goods company performance in emerging markets highlights how hard it has been so far to turn revenue growth into value. This will not change in the future. Emerging markets are becoming richer but the new “middle class” will be relatively much poorer than the equivalent group in developed markets. Price levels will need to be adjusted accordingly to match income levels. In addition, products and services will have to be tailored to reflect local market characteristics which will increase costs and impact margins. Ultimately, new business models may be needed to ensure shareholder expectations can be met.
The reaction to recent events has highlighted how investors took their eye off the relative riskiness of emerging markets. In recent months, we have seen major swings in currencies and valuations, massive shifts in funding costs and availability and increased political unrest. Investors need to think through how the environment and relative riskiness of certain markets should be reflected in their decision making metrics.
Finally, as the dust settles, the importance of China in shaping the emerging markets story is becoming clearer. China’s growth has slowed down from the rate it was achieving 5 or so years ago but the question is will it slow down further? Clearly China is a large and powerful economy but it must rebalance its economy over the medium term and reduce its dependence on investment and exports and increase the consumer share to achieve long term sustainability. This will not be an easy task even with the levers available to the Chinese authorities and there are likely to be bumps in the road and potentially a long term growth rate below the 7% or so currently being achieved. Investors must be realistic about China’s potential and aware of the exposure of their assets to changes in China’s performance.
All the signs are that the emerging economies will grow faster than developed economies over the medium to long term. However the differential is unlikely to be as great as it was in the last decade, volatility is likely to be higher and risk greater. Moreover, the relationship between revenue growth and value growth will not be linear.