Are emerging-market gains permanent?

Western Asset debates the durability of the recent shift in power from rich industrialised countries to emerging markets.
Are emerging-market gains permanent?

Will the shift in economic power from the developed markets to emerging markets persist? That may depend on what counts most between emerging and developed markets: growth, demographics or innovation.

Those were the fields of battle at a client presentation put together recently by Western Asset, which the US firm has promoted around the region in the form of a debate.

Western was keen to stress it wasn’t arguing for or against investment in emerging markets, but to talk though a vast change in the backdrop of global finance.

That aloofness made the ‘debate’ a little too genteel. But it was an interesting way to think about how the world has changed, and where we might be headed.

Since the 2008 global financial crisis, it’s fair to say that several aspects of the status quo have changed: developed-market government debt is no longer accepted as ‘risk free’, those economies no longer lead the world in growth, and EMs are more resilient than risky.

The permanence of the shift from DM to EM leadership depends in part to the extent to which emerging markets continue to outpace industrialised nations’ GDP expansion.

Although developed markets will not outpace emerging ones, the pace of EM expansion does not seem sustainable. Over the past decade, emerging markets outgrew developed ones by a factor of 5x, or by about 5% on an annualised basis. The growth gap will narrow to the point that distinctions between EM and DM should fade, argues Mark Hughes, a Pasadena-based credit analyst at Western.

Several factors supported that growth: a growing working-age population, the West’s outsourcing of manufacturing, better economic policies and decision-making institutions among EMs and, for some, the commodities super-cycle.

Hughes, charged with arguing that the shift between EM and DM is not permanent, says all of these factors are changing. As a result, the idea of ‘emerging markets’ is losing its meaning, as some will fare well and others poorly, and all will remain highly correlated to rich developed countries through trade and financial markets.

He could have gone further, by noting that divisions are opening among developed countries, too: the fortunes of the US seem to be improving, particularly when compared to the eurozone, but also vis-à-vis many emerging markets, thanks to cheap energy, cheap food, cheap housing, decent demographics, its culture of innovation, a flexible labour force, and so on. Nor did he mention the words ‘middle-income trap’, which surely weigh heavily on many EM leaders today.

At any rate, Hughes says what matters now is whether conditions exist for EMs to maintain their high level of growth, and what relationship they have with DMs.

Taking the side of permanent paradigm change, Western’s Asia bond portfolio manager Lian Chia-Liang says decoupling is irrelevant in a globalising world. Structural changes are afoot that allow EMs to shape their own destinies. Nations such as China impact financial markets and corporate plans around the world. Lian argues that EMs should no longer be considered a separate asset class, but incorporated into a global asset allocation.

That said, while Lian acknowledges that some EMs are basket cases, he notes that all developed markets are suffering downgrades and negative credit outlooks. Just a few years ago, all developed markets enjoyed credit ratings of single-A and above, and there was no debate about how to define ‘risk free’. Today differentiation is the reality.

And a gradual maturation and opening of EM capital markets will enable them to participate in global finance in the same way that their GDP growth has won them influence. In the absence of triple-A sovereigns, more global money will flow to substitutes, which means a steady broadening throughout the better EMs.

One line of attack that Hughes chose not to deploy was to question whether that substitution was best done via triple-A-rated corporations, rather than emerging-market governments. Top-quality multinationals are the winners from globalisation, often with earnings derived from growth markets. But investing in these, rather than by geography, would surely favour the continued dominance of developed countries.

There are also doubts as to whether the Bric nations have the ability to shift to domestic-demand societies. Corruption and vested interests suggest all four of these countries will remain wedded to economic models that are rapidly going stale.

This is another area where Hughes could have been a bit more punchy. He made the argument that China in particular faces huge costs of taking care of its elderly, without a proper social safety net or healthcare infrastructure. China will need to save more, change the pattern of its spending. As its working-age population declines, so will its GDP growth.

Lian’s response is to note that emerging markets do not simply mean ‘China’. He says Africa, Latin America, the Arab world and parts of Asia are younger. Compared with the multi-year, seemingly endless problems of aged developed countries, emerging markets are in a “sweet spot”. As for China, Lian says the demographic picture will require China to be less obsessed with the rate of growth, and more focused on its quality and how the economy is retooled for a new development strategy.

Hughes could have challenged this assessment. Many EMs have serious demographic challenges, including Russia and Eastern Europe and most of East Asia. Even India isn’t that young any more, and while it still enjoys another decade with a rising working-age population, its poor infrastructure and educational capacity means much of this ‘dividend’ will go to waste. Yes, the Middle East is full of young people, and – fingers crossed – the Arab Spring will lead to a prosperous summer. But that now looks years away.

Also, within the developed world, while Japan, Germany and Italy have appalling demographics, the same is not true of the US, the UK, France or the Nordic countries. Conditions there are moderate, and the US will see its working-age population rise over the next decade.

This is an area where the emerging markets have obvious gaps from developed countries. The educational capital resides in rich countries, as represented by the US university system. R&D spending remains far greater in developed countries. EMs continue to lack robust intellectual property rights, and their educational systems are often dominated by rote memory and a culture that doesn't admire questions or free thought. In a world led by IT entrepreneurs, that’s a problem.

Although Lian more or less conceded this argument, he could have found stronger arguments. For example, today US universities do indeed dominate. But at the primary and secondary levels of education, the US is mediocre, while some Asian countries are good or even excellent, at least in spots.

Also, the US university system is a disaster waiting to happen, given the heavy student debts incurred by many Americans who can no longer afford them; the ridiculous inflation for a university education; increasing competition from abroad; and the likelihood of devastating government cuts to support of state institutions and education in general.

Lian concedes that Asia is unlikely to develop anything like Silicon Valley, but he doesn’t mention the Chinese, Indians and other foreign bright sparks who have worked there and can take their ideas and experience home. Maybe the world needs only one Silicon Valley, but the benefits become more widely spread.

While listening to this debate, I found myself on the other side of the consensus. From a growth perspective, I think many key emerging markets will struggle to maintain pace. From a demographic perspective, I think EMs will do worse.

But from an innovation point of view, which Hughes and Lian seemed confident was the strong suit of developed markets, I wonder. If the shift of power from developed to emerging markets is to be permanent, this is the deciding factor.

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