The Case for Emerging Markets

Running an investment business in the US that focuses exclusively on investments outside of the country and in Emerging Markets is a somewhat unusual paradox. Allow me to explain my reasoning as to why I believe Emerging Markets present tremendous opportunities for investors. It’s pretty much accepted that economic growth prospects in the United States are lower than those abroad. This is due to a variety of reasons, but two facts in particular back this hypothesis.

The first is that a weaker dollar means high inflation and low real wages. The continued printing of money by the Federal Reserve and the increasing government deficit leads to a weaker dollar, which in turn leads to higher commodity prices and therefore higher input costs. If inflation is high, real wages (the actual value of the money workers receive) decreases, eroding purchasing power. The US economy is 72% consumer-based, so the effect of lower consumer purchasing power is quite real.

Secondly, the developed US market has high levels of competition which result in low or decreasing margins. As margins decrease, fewer businesses make outsized returns which gives rise to lower economic growth. There are probably fewer opportunities for higher returns in the US currently than there were 20 years ago.

For the last 30 years, the United States’ tangible competitive advantage has continued to erode. This has been caused mainly by a massive debt overhang that has existed for many years. In dollar terms, public debt is expected to rise from $5.8 trillion in 2008 to $14.3 trillion in 2019 (from 41 percent of GDP to 68 percent), according to the Congressional Budget Office.

Since 1999, Emerging Markets have been financing industrial economies (including the United States). In most Emerging Markets, such as China, Brazil, India, Russia and South Africa, the current account (exports – imports) provides income which is then invested mostly in US government debt. The United States is then able to fund this deficit with these borrowings. This situations means many emerging economies have stronger fiscal positions than their Western rivals; they are the creditors financing the American budget deficit.

As investors look to the future, I think Emerging Markets have many clear advantages over their developed rivals.

Since 2000, US Debt has been increasing while Emerging Market Debt has been decreasing. According to the International Monetary Fund, at the end of 2009 the US had a debt to GDP ratio of around 85%, while a basket of Emerging Markets was around 26%. This is a significant difference and will most probably allow for much quicker and efficient economic development in Emerging Markets.

So why are Emerging Markets a good investment case? For the last 20 years emerging market growth has exceeded that of the US, and this is forecast to continue for the next 20 years. The critical variable, in my mind though, is the imminent emergence of 1 billion new people into the “middle class”. Currently this is occurring all over the world, most notably in China and India but also large parts of Africa. Logically translated this means 1 billion new buyers of cars, houses, electronics, loans, cell phones, better quality food & clothing and financial products.

Emerging Markets also have another factor in common, which is the large infrastructure developments that are currently underway. In almost all Emerging Market countries, new power plants, roads, railways, telecommunications networks, and large scale urbanization are common-place.

What relation does all this development have on stock and bond returns in those countries? Well, Emerging Stock Markets have outperformed the most Developed (G7) Stock Markets since 2001 by over 200% (see this very cool tool, courtesy MSCI Barra, allowing for such comparisons).

Given these developments and the drive to move large parts of their respective populations into the middle-income bracket, Emerging Markets are rightly called the world’s “Engine of Growth”. On average they are forecast to grow at 6% in 2010 versus 4% global growth, according to Deutsche Bank. To make the case even stronger, as measured by share of World GDP, Developing Economies exceeded the USA for the first time in 2007. Plainly speaking the effects of such a shift is that the Developing Economies are now a bigger part of the global economy than the United States, which is a very significant structural change and is predicted to continue in the future.

Given the above facts, my conclusion is that the global economy is undergoing structural change. As a result, I firmly believe that Emerging Market exposure is necessary for investors in order to diversify out of low growth United States, generate higher returns on capital and take part in the next “industrialization” of the global economy.

For reference purposes, G7 includes USA, Italy, France, Germany, Canada, UK and Japan, while Emerging Markets include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.