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Emerging Markets: A Bright Spot?

Emerging markets are often cited as having long-term investment potential, yet they have underperformed since late 2010. This has left some investors wondering if the case for investing in these countries still holds. Are their problems insurmountable?

Taking a closer look at these countries, you'll see that a key reason for underperformance has been persistent inflation. In order to keep inflation from spiralling upward, emerging markets have had to raise interest rates to suppress growth.

But the story may be about to change. Ironically, the global economic slowdown currently in progress could, in an unusual way, benefit emerging markets. The reason is that inflation, which tends to follow growth with a lag, is likely to slow, allowing for the central banks of emerging market countries to stop raising rates. This could reduce the possibility of a hard landing, when growth slows too much, and ease pressure on stocks in these countries.

Why has inflation been a problem?

Emerging markets have generally been growing too fast. For example, in 2010, China's economy grew 10.3%, while Brazil's economy grew 7.6%. With strong economic growth, the demand for labor has increased, which has put upward pressure on wages, particularly in China. Higher wages can stoke inflation, as wages are an input for a broad range of products and services.

Additionally, unlike the tight lending conditions in the United States, there has been plenty of money available in emerging markets, particularly in China and Brazil. High rates of growth in emerging markets have attracted inflows of money from abroad and government-controlled banks have been ordered to loan, sometimes at what appear to be subsidized rates. In this case "too much money chasing too few goods" has resulted in higher prices.

However, the main reason that inflation has been rising is higher food prices. While US consumers are all too aware of the higher price of gasoline and energy, the commodity that matters most in emerging markets is food. Food accounts for 20-50% of household spending in emerging markets, compared to less than 14% in the United States.1

Emerging markets may outgrow developed markets but may not be an engine for strong global growth

In many developed markets, high levels of government and household debt are dampening growth prospects. This in turn puts pressure on employment and/or wages, and consumers have little room to fund spending from borrowing. High levels of government debt are pressuring public spending as well. In contrast, the growth outlook for emerging markets is brighter. Emerging markets tend to have low income bases from which to grow, young demographics, natural resources, and in many cases, low levels of public and private sector debt.

However, emerging markets are not likely to be as strong an engine for global growth as they were in the past, as their ability to pursue stimulus to the same degree as in 2009 is limited. In addition to still elevated levels of inflation, headwinds for emerging markets include:

  • Excessive lending. China's local governments have borrowed to construct infrastructure and Brazil's consumers have relied heavily on credit for spending. As a result of strong growth in lending, there's the risk these loans turn bad in the future.
  • Elevated government spending. Brazil and India need to redirect fiscal spending from social programs toward productivity-enhancing investments. At the same time, these countries need to control fiscal spending so interest rates can be reduced.
  • Infrastructure needs. Indonesia's growth is constrained by the dire need for updated infrastructure but a large fiscal deficit limits their ability to fund it. India's food inflation may be a long-term fundamental issue due to low crop yields, lack of irrigation and sufficient infrastructure.
  • Government bureaucracy. Government bureaucracy and concerns about corruption have stifled foreign investment in both India and Russia.

Despite the headwinds, in a world of weak growth, emerging markets may have better growth prospects than developed markets in the near term.

What do we need for emerging markets to outperform?

I believe three main conditions must be met for emerging markets to begin to outperform developed markets:

  • Pause in rate hike cycles
  • Drop in food prices
  • Reduction of general market volatility

Eurozone and US debt concerns have increased market volatility and have made asset classes move more in tandem, or in high correlation. During times of market stress, investors can tend to paint all investments with the same brush instead of weighing individual merits. Additionally, emerging markets tend to underperform during times of uncertainty as they are typically viewed as being higher risk. However, when market volatility subsides and correlations fall, possibly due to an easing of eurozone debt concerns, emerging markets could begin outperforming developed markets due to their brighter outlook potential.

1. BCA Research, February 2011, and US Bureau of Labor Statistics, August 2011.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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