How Emerging Markets Got Their Mojo Back Once Again

Emerging markets’ time may be coming–again. The stock index that tracks EM, as they’re known, has vaulted by 62% over the past two years, at the end of their recent economic downturn. That’s 20 percentage points better than the Standard & Poor’s 500, the US equities benchmark.

Meanwhile, about $25 billion in investments have been flowing into emerging markets equities funds thus far this year, and some $15 billion out of US ones, according to EPFR Global. Only in mid-February did that situation reverse itself, albeit slightly. The trend still seems to favor EM.

The last time emerging nations’ stocks were hot was coming out of the tech bust in 2003 until the 2008 financial crisis. The MSCI emerging markets index expanded more than fourfold then, versus about one-third for the S&P 500.

After tumbling in the Great Recession, the MSCI index popped back up with global recovery, only to founder anew in 2015 and early 2016, amid sliding oil and other commodity prices. (The US market and other developed-world bourses mainly were flat during that time.)

But once oil and commodities turned around in February 2016, so did EM’s stock performance. To Frank Rybinski, chief macro strategist at Aegon Asset Management, cheaper valuations in EM shares make them attractive. Their superior economic growth prospects are even more enticing. “They’re earlier in their business cycles,” he said in an interview.

This means that, unlike the US and kindred developed nations where growth has been slow and steady since 2009, EM countries began their latest rebound only two years ago, and hence have more room to grow.

More broadly, EM nations are expanding faster. In the developed world, economic growth is tepid, around 2% at best. Aging populations there, with legions of baby boomers retiring daily, are one reason. EM societies, for the most part, have more young people and swelling workforces.

Seven of the most prominent EM countries (China, Russia, India, Brazil, Turkey, Mexico, and Indonesia) will account for a bit more than 50% of the world’s economic growth in 2019, estimates the Brookings Institution. By contrast, the Group of Seven, or G-7, advanced economies (the United States, UK, Canada, France, Germany, Italy, and Japan) will contribute just 25%. In each group, China and the US make up about half of the new output.

In other words, the seven top EM economies will increase an average 4.8% this year and accelerate to 5.2% in 2019, by Brookings’ reckoning. Meanwhile, the G-7 is projected to increase by 1.7% in 2018 and slow to 1.5% next year.

For a long time, what was once called the Third World had no growth to speak of. The reason was countries weren’t “adopting market-oriented policies and allocating resources according to demand,” Mark Mobius, long-time head of Templeton Emerging Markets Group of mutual funds, told Barron’s.

Then came a radical change. The biggest example: China’s paramount leader from 1978 to 1989, Deng Xiaoping, pushed his country to adopt market-based reforms that led to its prominence today, when it is the world’s No. 2 economy. That’s the result of a growth rate that, at the outset, was in the teens. This pace has been slowing in recent years amid China’s policies to curb its whopping debt and contain a real estate boom, with 6.9% as its most recent reading.

To be sure, none of these countries is an impregnable tower of strength. They all possess weaknesses that could hobble them going forward–such as, for some, a reliance on commodities, whose value is inherently unstable. These nations tend to have overbearing governments, spotty adherence to the rule of law, and questionable corporate governance. And unlike in the developed world, they have few multinationals and are tied to the economic conditions within their borders.

Take India, which is often touted as the next EM powerhouse, following China’s example. The sub-continent boasts a large cadre of young, educated workers fluent in English, the world’s business language. Economic growth should be 7.4% in 2018 and 7.8% in 2019, the International Monetary Fund believes.

Its prime minister, Narenda Modi, has sought to streamline the nation’s commercial system with such controversial steps as curbing unions and thus allowing employers greater freedom to hire and fire, and permitting the government to seize farmland to convert to industrial use.

India, however still struggles with basic problems like overcrowding and poverty, sub-standard roads, and sanitation.

And the top EM economies have their laggards. Brazil’s growth will be just 1.9% this year and 2.1% next. This commodity-rich nation is only slowly climbing out of the recent recession, as depressed prices for its coffee, sugar, iron, and copper finally nudge upward. A major weight is the huge debt it took on in recent years.

Plus, Brazil has a big corruption problem, with one previous president convicted of corruption, his successor removed from office on other corruption charges, and the current one accused of accepting bribes. A culture where officials’ palms need to be greased doesn’t inspire business confidence.

Nevertheless, stock markets anticipate the future, betting on what they collectively believe that investors will face. And the market verdict on EM nations is thumbs up: In the past two years, China’s Shanghai composite rose almost 11%, Brazil’s Bovespa index doubled, and India’s Sensex index climbed 43%.

So, investors, at least, are pleased with EM once more.