Emerging market macro-economic evolution and outlook

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1 Emerging market macro-economic evolution and outlook Emerging market secular growth remains on track The environment for emerging market investing remains challenging in the short term: several countries are undoubtedly grappling with difficult issues and need to implement reforms. However, emerging markets have been on a secular growth trend for two decades. We believe bumps in the road like the recent sell off will not change that. In fact over the last few decades, numerous crises and the many bumps in the road are precisely what have driven long term secular improvement in the emerging market investment environment. For those of us who take a long-term view, these crises (i.e. Tequila Crisis 94, Asian Crisis 97, Russian and Argentine Crisis in 98) have largely turned out to be beneficial. They have provided the impetus behind structural reform and the strong, secular longterm outlook for emerging markets. We believe that in the decades to come emerging markets will play an ever-greater role in, and make up a larger share of, the global economy. Consumption and the growing status of the emerging market consumer will be at the heart of this growth story. According to the IMF, emerging markets now represent 50% of global GDP based on Purchasing Power Parity (PPP). Higher growth rates remain concentrated in emerging markets and they are forecast to increase their share further to 54% by 2018, eclipsing developed markets. Exhibit 1: Higher growth rates remain concentrated among emerging markets real GDP growth forecasts Annual percent change 10% or more 0% 3% 6% 10% less than 0% 3% 6% no data Source: International Monetary Fund Data Mapper and World Economic Outlook as at October 2013 thecapitalgroup.com/emea 1

2 China is now the world s second largest economy and is expected to eclipse the US within three years. Four of the 10 largest economies in the world are emerging markets (Brazil, Russia, India, China). We are no longer living in a G7 world but really a G20 world. China is now the world s second largest economy and is expected to eclipse the US within three years. Four of the 10 largest economies in the world are emerging markets (Brazil, Russia, India, China). We are no longer living in a G7 world but really a G20 world. So this is the context of the market s recent reaction to Fed quantitative easing tapering. Gradually more people are realising that the negative reaction was perhaps overdone. It is worth remembering that as tapering began emerging markets were in a position of economic strength far stronger than in the 1990s. Even the so-called fragile 5 (Brazil, India, Indonesia, South Africa and Turkey) who have large current account deficits and therefore are the most exposed to capital outflows, are today in a better position than they were during the Asian crisis of These structural and macro improvements have been centred on three axes: economic management and capital, demographics, and management innovation and productivity. 1. Economic management and capital We have seen good financial management lead to stronger and more stable investment flows. Since the 1990s the amount of Foreign Direct Investment (FDI) flowing into emerging markets has increased over 20 times. The amount of FDI flowing into emerging markets has in fact, according to the United Nations, grown larger than the amount directed at developed markets. In 2012 $702 billion of FDI flowed into emerging markets, while $560 billion went to developed markets. Behind these achievements are four key aspects: Better economic governance Economic governance has transformed since the 1980 s and 1990 s as governments have worked hard to better establish their economic credibility, particularly in fighting inflation. One example is Brazil, where hyperinflation was the norm, until 1994 when the Cardoso government implemented the Real Plan. The Plan ended automatic inflationary pay increases for all employees, broke the inflationary vicious circle and convinced investors that the country was a safe place to invest. Another example is Turkey. During the 1980s and 1990s it faced serious macro imbalances and was mainly financed by short-term capital inflows. In 2000 and 2001 Turkey experienced a severe banking crisis resulting in bank failures, sky-high interest rates, and the abandonment of exchange rate controls. The IMF stepped in with $30 billion of assistance. The crisis marked the beginning of far-reaching structural reforms which ended dependence on short-term capital and allowed rapid but sustainable recovery. State banks capital structures were improved and banking laws were reformed. Thanks to these reforms and the creation of a stable banking sector, Turkey was able to weather the global financial crisis. While Turkey currently faces other challenges, its banking sector passed the ultimate stress test thanks to post-2001 reform. Many of these structural changes are the reason why most emerging markets were better positioned to weather the global financial crisis than developed markets. Increasing prevalence of floating FX rates has helped build resistance to external economic shocks. Emerging market currencies have progressively been allowed to trade more freely over the last 20 years. While there is still a lot of currency management taking place, few currencies remain fully pegged to the dollar. This relaxation in currency 2

3 While domestic credit has increased rapidly in some emerging market countries, many emerging market governments and private sectors are still less leveraged then their developed market counterparts. controls, in combination with credible inflation targeting, has allowed markets to resist external shocks with reduced fear of crisis. To give a few examples: In 1999 the Brazilian central bank was forced by a deterioration in international markets caused by the Russian default, to abandon its tight control over the exchange rate and move to a floating exchange rate regime. In Russia, the Rouble has seen a gradual move toward an increasingly flexible exchange rate mechanism. In 2004 less restrictive capital control regulations were adopted, and since 2009 the Bank of Russia has gradually decreased intervention volumes. Now the Bank of Russia plans to transition to a fully floating exchange rate regime by China has also seen dramatic changes in its exchange rate policy since the 1970 s and 1980 s. The Chinese renminbi was pegged to the US Dollar for much of this time, but with the emergence of China as an exporter, the currency was allowed to devalue throughout the 1980s and 1990s, and the peg finally lifted in The renminbi is now in a highly managed floating regime, and kept within tight, but loosening bands against the US dollar. The bands have increased from +/- 0.3%, and were increased to +/- 2% from +/-1% as recently as March this year. While the People s Bank of China has pledged to allow the market a greater role in determining the exchange rate, this will probably be a long, drawn-out, process. Reduced threat of credit contagion Currency mismatches have been greatly reduced or removed. Foreign currency borrowing, particularly short-term bank lending as a percentage of GDP, is today much lower than prior to previous emerging market crises. For example, Asian bank lending has halved as a percentage of GDP from 29% in 1996 to the current level of about 14%. Unlike in the 1990s, we think that today s lower levels of cross-border credit could help insulate some markets from acute stress. While domestic credit has increased rapidly in some emerging market countries, many emerging market governments and private sectors are still less leveraged then their developed market counterparts. For example, the country with the lowest private sector debt as a percentage of GDP in the MSCI Emerging Market index is Mexico at 26%. The lowest in the MSCI World is Belgium at 93%. Even the highest compare well: Thailand at 140% versus Denmark at 208%. National balance sheets are far healthier As well as reducing borrowing in foreign currencies, emerging market Central Banks have sensibly built a cushion of foreign exchange reserves. For example, in Russia foreign reserves have increased seven times since 2003 and currently stand at US$440 billion. Brazil has seen a 50 fold increase since 1987 ($370 billion today). And China has Exhibit 2: Emerging market countries are less leveraged than their developed market counterparts. MSCI emerging market countries Private sector credit as % of GDP MSCI world countries Private sector credit as % of GDP Lowest Mexico 26.1 Belgium 92.6 Highest Thailand Denmark Source: Fitch (December 2012). 3

4 41% of Africans are aged under 15, compared to a global average of 26% being under 15. This burgeoning youth population has become known as Africa s demographic dividend. nearly $4 trillion of reserves, more than 50 times greater than in While we may see reductions in these reserves when countries defend their currencies, the comparison with 20 or 30 years ago is stark. Perhaps the most salient point today is that these countries can afford to defend their currencies without lowering their reserves to worrying levels. 2. Demographics support long term growth, stability and the consumer thesis Younger populations Compared to developed markets, many emerging market nations have younger populations, more people entering working age and rapid urbanisation. These people want to raise their standard of living to match the developed world. 41% of Africans are aged under 15, compared to a global average of 26% being under 15. This burgeoning youth population has become known as Africa s demographic dividend. This generation has higher expectations than previous generations of lives with mobile phones, restaurants, frequent travel and other aspects of urban living. However, it is important to be selective in this area as certain emerging market countries and markets are approaching a point where the transition in their demographics will start to tilt against growth. Emergence of middle class supporting stability and consumption By 2030 it has been predicted that a further 1.3 billion people will reach middle-income levels in emerging markets. Some countries will see their middle classes grow faster than others. For example, Egypt, Indonesia and the Philippines will in combination add more to their middle-classes than either Brazil or Russia. These countries are becoming more stable. Economies with more than $6,000 GDP per capita can support democracy over the long term 1. Rapid urbanisation in emerging markets drives domestic consumption growth Rapid urbanisation trends in emerging markets are mainly driven by rural populations migrating to cities in search of work. In 2011 the World Bank forecast 1. Source: Democracy and Development: Adam Przeworski et al (2000) Exhibit 3: Higher growth rates remain concentrated among emerging markets. Working-age population as a percentage of total population: % Developed markets Population estimates US UK Japan Germany Brazil Russia India China Indonesia Malaysia Turkey 2025 (millions) ,396 1, annual % growth 0.68% 0.44% -0.26% -0.18% 0.60% -0.15% 1.00% 0.22% 0.71% 1.17% 0.84% Source: US Census Bureau. 4

5 By 2030 it has been predicted that a further 1.3 billion people will reach middle-income levels in emerging markets. that urban populations in emerging markets would grow by 2.5 billion between 2010 and In developed markets this growth was forecast at just 170 million people. It is estimated by McKinsey that 440 of the largest cities in emerging markets will contribute 47% of global GDP growth between 2010 and 2025 with emerging markets as a whole providing 74% of global GDP growth. Inhabitants of urban areas spend and consume more than their rural counterparts and also drive infrastructure spending. 3. Management innovation and productivity 20 years ago, especially in former centrallyplanned economies, there was no quality of management. This posed a big challenge because quality of management is essential to the success of an investment. Today, the situation is transformed. We come across a plethora of management talent in emerging markets. We no longer compare them only with emerging market peers but we can easily benchmark them to global peers. Valuations are close to 10-year lows Valuations for equities must be approached on a company-by-company basis, but it is fair to say that many companies in emerging markets are trading at discounted valuations relative to their developed-market peers and relative to their history. The differential in Earnings per Share (EPS) growth between emerging markets and developed markets has grown narrower in recent years. Looking ahead to next year, EPS growth for emerging market corporates is predicted to grow in double-digits (11% in 2015 and another 11% in 2016). But developed markets will only grow in single digits (8% in 2015). While the valuation argument is especially compelling today after the sell-off, it is the core case of reform and underlying economic progress, demographic promise and the growing pool of management talent that truly underpin the case for emerging market investing in the coming decades. Exhibit 4: Emerging market versus developed market price-to-cash earnings. MSCI Emerging Markets Index vs. MSCI World Index 1.40 Relative price-to earnings (%) Premium Discount May 90 May 93 May 96 May 99 May 02 May 05 May 08 May 11 Line signifies the average relative price-to-earnings for EM v DM, from May 1990 to April Data as at 30 April Source: Thomson Reuters Datastream. FOR INVESTMENT PROFESSIONALS ONLY All data as at 31 March 2014 unless otherwise stated. The statements expressed herein are opinions of the individuals identified, are as of the date published, and do not reflect the opinions of Capital Group or its affiliates. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited. This communication is issued by Capital International Limited (authorised and regulated by the UK Financial Conduct Authority). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice Capital International Limited. All rights reserved _0514 5

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