The conventional wisdom is to “go where the growth is.” As a result, many advisors have recommended that investors add to their emerging markets holdings over the past five years. Unfortunately, for many, this strategy hasn’t worked as planned, especially for those invested in passive index funds. Despite gross domestic product (GDP) growth that’s continued to be more than two times that of the developed world, emerging markets equity returns have been disappointing (see “A Slow Recovery,” this page), falling well short of the S&P 500 and not yet returning to the previous highs of 2007. Now, as the United States begins to show signs of recovery, concerns about the emerging markets have increased, as China tightens credit, GDP growth rates decelerate and civil unrest erupts in Brazil, Turkey and South Africa.
So, what’s an investor to do? Emerging markets investing continues to be more complicated than just utilizing economic growth projections. As I noted in a prior article,1 there’s never been a strong relationship between country-level GDP growth and returns in the emerging markets. More than ever, investment success depends on a company-by-company analysis and an ability to see how and where companies generate revenues and profits.
For many decades, a company’s country of domicile had a large influence on the underlying security’s returns. However, starting in the late 1990s, industry and company-specific factors began to have a far greater influence.2
In an integrated global economy, traditional investment approaches that define geographic allocation based on a company’s country of domicile are becoming less relevant. Most large- and mid-sized companies have some combination of customers, suppliers and production facilities in multiple countries. Therefore, the country where a company is incorporated or has its headquarters may provide little information about its potential success or future stock price. The domicile approach to measuring geographic exposures—long one of the primary building blocks of asset allocation—increasingly is disconnected from the fundamentals that drive companies and portfolios. Instead, looking at a company’s (and a portfolio’s) economic exposure, using revenues as a proxy, may provide better information.
Many of the companies that are benefitting from growth in the emerging markets are based in the developed world. Indeed, if we look at the share of revenues that come from emerging markets, we see that almost half of the emerging markets revenue exposure is embedded in developed world-based companies. (See “Where’s the Revenue?” this page.) These trends are likely to continue. The global economy is structured differently from the way it was just two decades ago. Free trade agreements, the European Union and its common currency, economic reforms and the rise of a middle class in Asia, Latin America and parts of Africa have allowed companies to compete for customers, labor, capital and natural resources on a global basis. Average tariffs have declined from 26 percent in 1986 to 8 percent in 2010. Exports as a percentage of GDP have grown to almost a third of global activity, compared to 20 percent in 1994 and 15 percent in 1973. Economies are more closely linked than ever.
That said, there are still plentiful investment opportunities in the emerging markets themselves, though, arguably, future success will depend on identifying individual companies benefiting from these trends, as opposed to just buying the index itself.
Shift in Opportunity
Part of the reason that the emerging markets index has lagged is because it’s overweight in sectors that previously benefitted from the infrastructure build, such as materials stocks, which remain more than 40 percent below their pre-crisis levels (see “Growth Leadership,” p. 58), and underweight in the better-performing consumer and health care stocks. (See “Underrepresented,” p. 58.) These stocks have done well because, as consumers move into the middle class, the first changes they make are to improve their health and to consume higher quality products. Many developed market-branded consumer goods companies and health care companies have also been benefitting from this trend.
It’s likely that we’re in the early stages of a shift in the investment opportunity towards the needs of an expanding middle class of consumers. For example, China accounts for only 4 percent of the world’s middle class today, but is projected to be the largest middle class market in the world by 2020.3
Deep Dive: China
In China, infrastructure-related sector growth has fallen from a multiple of GDP to a fraction of it, and services and consumption have yet to pick up the slack.
It’s challenging to get an accurate read on the state of the Chinese economy through data alone because official GDP figures aren’t always reliable. However, power consumption and rail cargo figures are often good proxies for industrial activity. Based on the latest readings, one could conclude that the present recovery is very weak relative to prior periods, and it appears that China has entered a new, lower growth phase. Demand for excavators, which are used to clear land, basically crashed after May 2011. The second shoe to drop is lower demand for cement pump trucks, which started to turn down strongly in recent months. Thus, infrastructure-related sectors may now have less growth potential.
Despite the desire of government officials to control the property market and stimulate consumption, the opposite has happened: Property remains strong, and consumption looks weak. Rising disposable income is a secular trend, and as the middle class expands, China may eventually shift to more of a consumer- and services-based economy.
The new government leadership is putting a number of reforms into place to help support consumer spending. They’re also boosting minimum wages to put more money in people’s pockets and loosening controls on interest rates to give household savers better returns. They’ve tilted tax and land incentives toward industries that cater to consumption, such as food and autos, and away from heavy industries. They’re also striving to enact urbanization efforts focused on reforming China’s household registration system or hukou. This system began as a way to keep track of taxation and social structure, but morphed into an internal passport system that restricts people living in rural areas from moving to urban areas and vice versa. Giving more migrant workers full city rights means local governments will need to spend more on housing, health care, education and social security. The bad news is that there will be less money to spend on infrastructure projects. The upside is that urban residents spend much more than rural folks. The past was about building up the urban area; the next phase appears to be about properly urbanizing more people.
Despite the slowdown, there may be some compelling investment opportunities in the consumer sector. Low-income consumers, for example, stand to benefit from the government’s emphasis on improving the social safety net. Wages for blue-collar workers are slated to increase more than 10 percent this year. Though this type of rise isn’t likely to turn these consumers into luxury jewelry buyers and collectors of fine wine, it will enable them to buy inexpensively priced everyday branded luxuries, such as cosmetics and other personal care products. Safety standards may also rise. Very few Chinese families use car seats, for instance, but this will change if they became mandatory by law in the coming years. When Brazil made them mandatory, the market grew 15 times.
Health care in China is in a near perfect storm of rising GDP per capita, an aging population, worsening pollution, diet and stress, rising disease awareness and increased government spending on health care and health insurance. Thus, the Chinese pharmaceutical market is projected to grow from $58 billion in 2011 to $162 billion by 2017.4 However, health care companies represent only 1.5 percent of the emerging markets index, so developed market companies have been the primary beneficiary to date. Within the Chinese market, though, there are companies that have a strong sales force and have shown the R&D strength to be first-to-market with generics. Success with generics may garner the profits and scale that should ultimately help them transition to novel drugs and medical devices.
These examples demonstrate the importance of researching companies in the developing world one-by-one, to ensure the fundamentals are in place to benefit from today’s changing landscape. While emerging markets still present many compelling long-term investment opportunities, the emerging markets index itself can be a suboptimal representation of them.
—The views expressed herein are those of the author and don’t necessarily reflect the views of everyone at Capital Group Private Client Services. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, are subject to change at any time and should not be construed as advice. There’s no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with a licensed investment professional.
1. Gregory D. Singer, “The Real Allure of Emerging Markets,” Trusts & Estates (April 2010), at p. 36.
2. “Global Equity Allocation: Analysis of Issues Related to Geographic Allocation of Equities,” MSCI (March 2012), http://www.regjeringen.no/pages/1934920/MSCI.pdf.
3. Brookings Institution, “The New Global Middle Class: A Cross-Over from West to East,” http://www.brookings.edu/~/media/files/rc/papers/2010/03_china_middle_class_kharas/03_china_middle_class_kharas.pdf.
4. McKinsey & Co., “Health care in China: Entering ‘uncharted waters’” (2012) http://www.mckinsey.com/insights/health_systems_and_services/health_care_in_china_entering_uncharted_waters.
To hear the author discuss investing in emerging markets, watch his video at http://videos.wealthmanagement.com/video/Greg-Singer.