Inevitably, we harbour old ideas that need to be refreshed. One of them concerns emerging markets which, since the concept was launched, have moved well past the "emerging" state.
Thirty years ago, MSCI introduced its emerging markets index which, according to the MSCI website, has grown "from just 10 countries in 1988 representing less than 1% of world market capitalization to 24 countries representing 13% of world market capitalization."
In fact, it is countries we identify as frontier markets that now "occupy the position of emerging markets 30 years ago," claims Adam Kutas, Toronto-based portfolio manager of the $59-million Fidelity Frontier Emerging Markets. It's a comment MSCI numbers confirm: the Frontier Markets index now includes 33 countries that represent slightly more that 1% of world market capitalization.
The most important countries in the index are Kuwait, Vietnam, Argentina, Morocco and Nigeria. "Frontier markets are up and coming, and emerging markets have now practically emerged," states Christine Tan, assistant vice-president and emerging markets specialist at Sun Life Global Investments, in Toronto.
But will frontier markets equate the stellar performance of emerging markets (EM)? After all, China and India are unique phenomena and tough acts to follow. China, with a population over 1.4 billion, exhibited yearly GDP growth rates above 10% for many years. India, with more than 1.3 billion people, is gearing up in the range of 7.5% yearly growth. Vietnam, the most dynamic among the biggest frontier countries, has a population of 95 million and its recent growth has turned around 6.5%. Nigeria's, with a population of 191 million, has been hovering around 0% in recent years, its fate closely linked to that of oil.
So the light of emerging markets still shines bright, and their story is very different from what it was 30 years ago. The old perception was that they were manufacturing sweat shops employing near-slave labour and driven by exports. It was the formula that ensured the success of countries like Japan and South Korea. It was certainly the formula for China, and increasingly for India. But that reality is now moving to frontier countries, especially the small number that neighbour China, like Vietnam, Cambodia and Bangladesh.
In the meantime, EMs have undergone deep transformations. "The Chinese are not buying their first TV set or their first car any more, but rather their second or third TV, and the second car in the driveway is a Range Rover," says Tan.
"China is the second richest country in the world and is working on an international space station," adds Kutas. "That's not your usual attribute of an emerging country. Taiwan and South Korea have per-capita revenues above $30,000 and their household debt ratios stand above 150%."
"Whether in India, Malaysia or Thailand, populations are increasingly educated and pressure for changes," says Tan. "In the 1970s, these citizens didn't think they could change much. Now, they believe it, and they're doing so. Millennials 27, very similar to the millennials here, vote for governments that will deliver empowerment and democracy."
We still perceive EMs as a monolithic block, but there also, very different realities have set in. China, Brazil, South Africa and the Czech Republic are all emerging economies but exhibit very different profiles. Indeed, EMs did behave as a block for a long time. "This was partially true through the commodity super-cycle years when the rise of China (through industrialization) pulled all commodity producers upward (Russia, Brazil, Colombia, Indonesia, Malaysia), and hence the correlation between emerging market countries rose over time, with a peak of nearly 60% in 2010," commented Kutas in a 2016 blog.
"However, since that period, correlations have moved down to nearly 30%. This is a very significant structural change in emerging and frontier investing that is generally overlooked by investors," Kutas wrote.
It is true that EM financial markets are still very synchronized with financial trends in developed economies and depend on the mood swings of Western financial markets. But EMs have significantly decoupled from their developed economies counterparts. For example, Kutas shows that only 7.5% of South Korea's exports, 7% of India's and 5.4% of China's are at risk from higher U.S. tariffs.
The internal financial situation of EM countries has significantly strengthened. Many have learned a hard lesson from the Asian crisis of 1997 and raced to detach their financial systems from developed market angst. "Many countries have unlinked their national debts from the U.S. dollar and now hold it in local currency," notes Tristan Sones, vice-president and portfolio manager with AGF Investments in Toronto.
Many countries have also increased their currency reserves. Whether it is Brazil, Argentina, Indonesia or Mexico, "most of these countries have fared much better through the crisis of 2008," adds Serge Pépin, investment specialist, global stocks, with BMO Global Asset Management in London.
Of course, even if they are shortening the distance between themselves and developed economies, EM countries are still in the process of emerging. They still house a lot of poverty and exhibit modest per-capita GDPs.
At a commercial level, their greatest weakness remains their strong dependence on exports, especially toward developed markets. "When world trade is healthy, EMs thrive, and vice versa," highlights Jean-Pierre Couture, chief economist and strategist, emerging markets, at Hexavest in Montreal.
But the "great decoupling" that started to take effect between developed and emerging countries about 10 years ago is intensifying. Many countries are growing their middle classes, while their interior demand and trade with other EM countries are continuously expanding, indicates Tan. According to a 2017 Brookings study, about 140 million people are joining the middle class annually, mostly in EMs, and "the vast majority (88%) of the next billion people in the middle class will be Asian (...) By 2030, Asia could represent two thirds of the global middle class population.”
For the first 10 months of 2018, the MSCI Emerging Markets index has plummeted by more than 11%. For a contrarian investor like Couture, this drop is a positive signal. "The valuations of EM stocks are in line with their historical averages (since 2000, price-earnings ratios stand at about 12.6 against 6.9 in the U.S.), while their U.S. counterparts are extremely high, Couture says. That means that, in the future, we can expect superior returns in emerging countries."
Still, investors should beware and read the signs carefully. Because a slide like the present one is not unprecedented. From November 2007 to March 2009, the index dropped by a whopping 61.5%. So this dive still has enough space to become a collapse. But then, from March 2009 to May 2011, the index regained practically everything it had lost.
