Pulling ahead

By bne IntelliNews September 27, 2010

Ben Aris in Moscow -

The landscape has changed completely as a result of the global economic crisis and in September Goldman Sachs released a report that recalibrates its classic 2001 paper that introduced the world to the idea of the Bric markets.

Jim O'Neill, author of the first paper, has now brought forward his deadline for when the size of the Bric markets - Brazil, Russia, India and China - overtake the developed markets by about five years to sometime in the next 15 years. Yet the new paper focuses not on the size of these economies, but the size of their equity markets.

For the last two decades, investing into emerging markets has traditionally been the preserve of risk-hungry investors looking for big returns. However, if the Goldman analysts are right, not only are "emerging markets" going mainstream, but institutional investors in the developed markets now have no choice - they have to invest in these markets simply if they want to stay in the game.

Marcus Svedberg, chief economist at East Capital, a leading emerging Europe fund manager, says it makes no sense to ignore the emerging markets. "Investors are still keen to invest in the slowly growing and highly indebted markets in Western Europe and the US when there are markets to the immediate east and south growing fast without much leverage," he says. "There is a lot of uncertainty in the market at the moment, but regardless how the short term plays out - we do not believe in a double dip but a slowdown in the developed world - the structural, long-term case for emerging markets is stronger than ever."

The main conclusion of the new Goldman report is that not only will the GDP of the Bric economies be bigger than the those in the developed world by 2030, but so will their equity markets. This is not a clever investment strategy, but simply the articulation of a fundamental change in the way the world works. For portfolio investors, it is about as sure a thing as you get in an open market; the only issue is how long the change will take.

Wealth disparities

The equity market capitalisation of the emerging markets has exploded over the last 10 years, rising from $2 trillion in 2000 to about $14 trillion today. At the same time, the market capitalisation of the developed markets has only increased from $29 trillion a decade ago to $30 trillion now.

That statistic is shocking, since by all accounts it should have doubled: numerous studies have shown that the long-term average return from equity investments is about 8% - which means that if you invest $100 in stocks, it should double in value every 10 years or so, not end up at $103. If you count inflation into the equation, then you have actually lost money, which the developed markets did over the last decade, down an average of about 20% in real terms, according to Liam Halligan of Prosperity Capital Management, a leading Russian investment fund.

Over the same period, emerging markets not only beat developed market investments hands down, they soared seven-fold: the same $100 invested in emerging markets would have been worth $700 at the end of the decade, according to Goldman's calculations.

Furthermore, Goldman says that while the pace of growth in the value of emerging stock markets will slow, they will still handsomely outpace those in the West: Goldman predicts that the value of developed equity markets will rise by half from $30 trillion today to $46 trillion in 2020, and slightly less than half in the following decade to reach $66 trillion by 2030. By 2030, the value of emerging stock markets will have reached $80 trillion and the world's financial centre of gravity will have shifted for good.

Shift to the east

So who will be the big winners if the emerging markets do indeed see the capitalisation of their equity markets increase six-fold again (this time over 20 years, instead of 10 - a nice geometric progression).

The four big Bric countries are expected to be the run-away winners, with China alone accounting for half the gains as the value of its equity markets rise to $41 trillion to become the largest in the world, with the US' dropping into second place at $36 trillion, predicts Goldman.

The "Next-11" (N-11) - another term coined by O'Neill - are the smaller emerging markets, which will do less well but still rise from $2 trillion today (about 15% of the emerging market total) to $8 trillion over the next 20 years (or 10% of the total).

Standard Chartered threw a new idea into the ring in September with a report on its "7% club." To be a member of this club, a country has to put in 7% GDP growth for a year or more. Out of the Bric countries, China and India easily qualify, but Russia's average 6.8% growth between 2000 and 2008 would have left it just shy and this year's 4% growth puts membership out of reach for the next few years at least. Brazil likewise is blackballed.

Turkey would be an obvious member after its growth topped 11% in the first quarter of this year, making it (briefly) the fastest growing country in the world. This club would also include many of the frontier markets in the former Soviet bloc that don't get much attention, such as Tajikistan and Turkmenistan, as well as the more mainstream ones of Azerbaijan and Kazakhstan. And they would be joined by a raft of off-the-radar countries from Africa, including: Uganda, Ethiopia, Mozambique, Angola, Sudan, Chad, Sierra Leone and Rwanda. Other countries that would probably qualify soon include Indonesia, Bangladesh, Nigeria, Tanzania and Mongolia.

And so it begins...

The shift toward emerging market funds appears to have already begun, though slowly and there is still a long way to go. "We estimate that developed market institutional asset managers currently hold 6% in emerging market equities within their total equity portfolio. This weighting may rise to 18% by 2030, implying net purchases of $4 trillion," says Timothy Moe and his colleagues, the authors of the Goldman report.

The fund tracker EPFR reports that unlike most of the developed market equity and bond funds, which attracted less money during the first half of 2010 than they did during the second half of 2009, emerging market equity and bond funds took in more money during the first half of 2010 than they did during the latter half of 2009. By mid-August, EPFR said emerging market bond funds had extended their year-to-date record inflows to $32.8bn, which trounced the previous full-year record inflow of $9.7bn set in 2005, while all emerging market equity funds extended their year-to-date inflows to $34.5bn.

Lipper, another fund tracker, said in September that assets in emerging market bond funds swelled by 42% in 2009, rising from €44.5bn to €63.2bn, yet such growth pales beside activity over the first seven months of this year, with a further rise in assets to €96.4bn by the end of July. "Emerging market products account for 29% of all flows into bond funds from European investors in 2010, with a further 27% moving into global products," Lipper says. "Assets have grown at a compound annual growth rate of 30% since the end of 2001. The growth rate since the low-point at the end of 2008 is nearly 70%."

Indeed, while the outlook for the developed markets remains shaky with the risk of a "double-dip" recession rising, in the emerging markets all the conditions that drove the last boom starting in 2000 are back in place: extremely low interest rates; sluggish growth at home compared with exceptional growth in the emerging markets; and cheap equity prices but strong earnings growth.

Prosperity's Halligan says the historical changes we are currently witnessing - the decline of Western hegemony and the eventual toppling of the US from its position as the world's biggest economy - were actually already playing out prior to when the sub-prime crisis began unfolding in 2007, but the economic crisis has speeded up the process. "As a westerner, I'm somewhat alarmed at the pace of our relative decline, the fact many Americans and Europeans will have to endure falling living standards - and the inevitable political fall-out that will bring. But as an investor, it seems to me that emerging markets are where the action is - and where the bulk of one's capital should be."

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