Many investors have been dismayed by the underperformance of emerging markets (EM) equities relative to their developed market (DM) peers in recent years. The big question now is whether the recent rebound in relative performance is structurally sound or just a temporary mean reversion.
In this, the second of two articles (you can read the first one here), we run through the fundamental, secular reasons why we believe the future for emerging market equities is bright.
Prospects for GDP growth are better in emerging economies
In a period of lower growth globally, investors are putting a premium on whatever GDP expansion they can find. While EM growth is not as rapid as it was, it is nonetheless very likely to significantly outpace that of developed economies. Differences that appear quite small — 4.9% expected annual growth for emerging markets versus 1.8% expected for developed markets over the period from 2015 to 2021 — compound to become major differences over time. If forecasts by the International Monetary Fund (IMF) turn out to be accurate, emerging market GDP will be over 27% larger by 2021 while developed market GDP will only have increased by 9% (see Exhibit 1). This spells a major opportunity for EM companies, not least as a significant knock-on effect from the increase in GDP would logically be higher consumer demand.
Exhibit 1: GDP growth forecasts from the IMF for different regions of the global economy (indexed)
Sources: IMF, BNP Paribas Asset Management, as of 9 February 2017
Population growth is another critical element in assessing emerging countries’ potential, and populations are expanding far faster in developing countries than in developed ones. This should of course drive increased demand for goods and services by both businesses and consumers. The higher emerging market growth rates also engender a radically different demographic landscape. Most of the people living in emerging economies will be aged under 35 by 2025, according to forecasts from the US Census Bureau, while in developed markets, most will be over 65.
What this means is that in the coming decades, emerging markets will have a higher and fairly stable share of the population that is of working age, producing goods, paying taxes and driving GDP growth – in contrast to a higher and rising share of the population in developed markets that has retired and is living off of previously accumulated wealth and social programmes.
A growing middle class
Ernst and Young estimate that three billion people will enter the middle class by 2030, mostly in emerging markets. From a global perspective, this increase will likely lead to the middle class in emerging markets evolving to dominate consumption. According to the Organisation for Economic Co-operation and Development, spending by the EM middle class is forecast to rise from 25% of global consumption in 2009 to nearly 70% by 2030.
While consumption overall rises in line with wealth, there is also a pattern referred to as the s-curve which explains how discretionary consumption changes as wealth increases. For example, the aspiration to be able to buy a car will, once the car is acquired, tend to be re-directed towards savings or buying luxury goods. This phenomenon highlights the appeal of emerging markets for many consumer goods companies as they target those countries where income levels can spur a sharp increase in demand. The increase in domestic, consumer-oriented demand in emerging market economies is in our view a significant opportunity for the future.
Urbanisation will create new consumers in emerging economies
The movement of populations to cities from rural areas is a further factor driving EM consumption growth. Compared to developed markets, urbanisation is still low: just 40% in Africa and 48% in Asia, while in Europe it is over 70% and in North America over 80%, according to UN data. Emerging market urbanisation is, however, expected to top 60% in Asia within the next 30 years. With greater urbanisation comes higher consumption, as workers move into non-agricultural sectors of the economy, earning higher incomes and living in an urban environment that offers goods and services not available in rural zones.
Productivity and structural reform
Productivity growth has been disappointing in developed markets since the global financial crisis, but it has been more resilient in emerging markets and the latest trends show it improving (see Exhibit 2). In the absence of rising trade or expanding credit, productivity is the one the most fundamental ways to spur GDP growth.
Sources: The Conference Board, BNP Paribas Asset Management as of 9 February 2017
Structural reforms are an effective means of boosting productivity and developing economies inherently have more potential for gains from reforms than do developed economies, be it from trade and the liberalisation of foreign direct investment, or reforms in the financial sector, labour markets, product markets, government institutions or the education system. The economic returns to countries from reform have historically been significant.
Emerging market equities have put in several years of underperformance, the longest on record, which in itself could argue for a continued turnaround in relative performance. The perceived weaknesses of emerging markets — either a disproportionate exposure to commodities or a reliance on Chinese growth — turn out to be less relevant. Longer term, the key drivers of emerging market growth remain intact, from faster GDP growth, better demographics, rising populations, an expanding middle class, and urbanisation, to structural reform and productivity gains. Volatility, currency and political risk will remain part of the emerging market package, but in our view the future for emerging markets remains brighter than it does for developed markets, and investors should look to capture the potential.
Published 20 April 2017
This article is a précis of a paper written by Daniel Morris and Quang Nguyen. The full version of this paper can be accessed here.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.