While our research focus is largely on extraordinary companies, broader themes ― structural and cyclical ― emerge alongside our investigations. On a recent trip the Emerging Markets Equities team took to Johannesburg and Cape Town, the following observations struck us as important generalizations across the developing world.
- Fragilities still exist in resource geographies. The sharp rally in EM equities (more than 40% since the bottom in January 20161) has been most pronounced in commodity exporters as spot commodity price gains ― and domestic recessionary conditions ― have improved underlying balance of payments, and led to large currency gains in countries like South Africa (i.e., Indonesia, Chile and Brazil). South Africa’s equity market is up 52%2 in U.S. dollar terms since its 2016 bottom. These improvements, as recent spot commodity prices suggest, are likely unsustainable as they have been underwritten by fragile credit reflation in China.
- Bottoming out is not the same as durable growth. The developing world is an enormously heterogeneous collection of countries, with domestic growth prospects varying widely. By and large, the structural growth prospects of most commodity-endowed geographies ― South Africa, Russia, much of Latin America and sub-Saharan Africa ― will remain limited. The restraint on growth in these geographies comes down to the screaming demand for structural economic reform.
- Sustainable EM growth will be concentrated in countries where social mobility permits durable domestic demand. Income inequality is, in our view, the dominant social and economic issue of our time. This is true in both the developed and the developing world. And unlike what populists pontificate, the issue is not with globalization, but rather with internal economic policies which are bereft of creative solutions to enhance social mobility. We continue to believe that China, where social mobility has been the backbone of three decades of superlative growth, will remain the dominant growth engine of the emerging world for the rest of this decade. Other growth engines will be concentrated in areas where structural reform takes root. We are hopeful that a clutch of other continental-sized countries such as India, Indonesia and the Philippines, are building momentum slowly around such reforms.
- South Africa, which has elements of both first and third worlds, is a stark reminder of structural inhibitions that undermine growth ― disparities of human and financial capital, of educational and entrepreneurial opportunity. The reality is that South Africa’s earnings growth will remain constrained as long as banks, retailers, business services and much of the formal sector of this vast economy remain concentrated largely in the highly penetrated top of the income pyramid. It has been clear for most of the past two decades that the business community agrees with these growth limitations and has responded with feverish efforts to diversify outside of South Africa ― largely into the United Kingdom, Australia and Continental Europe.
The Larger Picture for Emerging Market Economies
- The emerging market story has become increasingly nuanced from the halcyon days of 2003-2013. The emerging market middle class consumer story was never a truism that should have been generalized across countries with very different levels of social mobility. High commodity prices, unconventional global monetary policy, and rapid emerging market (EM) credit expansion off an unusually low base post 1997-99 crisis levels, supported unsustainably high real growth across much of the developing world. Those days are behind us.
- The world will remain turbulent as long as two unsustainable and reinforcing forces collide ― artificial interest rates and socially unsustainable levels of inequality. Low rates ― or zero rates in Europe and Japan ― create enormous valuation distortions and compound the problems of inequality by artificially raising asset prices. These policy rates have created zombie companies (i.e., shale oil) and propped up unsustainable emerging currencies like the South African rand (and more dramatically, the Turkish lira).
- The bond markets seem complacent. It was thrilling ― then shocking ― to see the bond markets’ failure to respond to President Jacob Zuma’s dramatic cabinet reshuffling and attempt at state capture. Although this dramatic assault on South Africa’s unusually great institutions was met with credit downgrades, the currency and equity markets’ response was unusually tepid. In our view, the global hunt for yield among debt investors ignores the structural fiscal and growth challenges in South Africa. Without significant political and economic reform, South Africa will be deprived of any sustainable real growth.
We continue to believe the case for investing in EM equities should converge with that of global equity investors more broadly. Our focus remains on investing in high quality companies ― those unusual companies with attributes of durable structural growth, sustainable advantage and enviable real growth options. We try to unearth such investments even in economies like South Africa or Russia where we are less inspired about macro growth prospects, but we look for appropriate prices. In South Africa, the rand seems vulnerable to us now, and we will wait for a better price.
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1Source: Bloomberg, January 21, 2016 – April 21, 2017.
2Source: Bloomberg, January 20, 2016 – April 21, 2017.