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Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini Emerging Markets Christian Takushi Macro Economist MA UZH Sous-directeur, BCV Asset Management 08.11.2013 1.5 hours Content 1. 2. Importance of emerging economies Structure of emerging markets 1. 2. 3. How to approach emerging markets 1. 2. 4. top-down bottom-up Characteristics of Emerging Markets 1. 2. 5. 6. • by Country & Asset Class Developed / Emerging / Frontier / Developing (currencies, capital restrictions, 24 hrs trading, geopolitcs) Overview of specific characteristics & financial risks Currency Risks Sovereign defaults: Long history of underestimated risks Major Macroeconomic challenges for Emerging Markets Give real life examples, pictures, Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 2 1. Importance of Developing Nations has risen significantly GDP PPP-adjusted - IMF Grouped Data 70'000 60'000 n USD Billions 50'000 40'000 30'000 20'000 10'000 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 20 12 20 14 20 16 20 18 - Advanced Economies Euro area Emerging & Developing Economies Source: IMF Macro Database, Eurozone data estimates before 1992 by Ch Takushi MA UZH Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 3 What are Emerging Markets ? • • Also known as « developing nations », emerging markets are economies that are experiencing rapid GDP growth, household income growth and industrialization. They differ from their « developed counterparts » in seven main ways. – Positive demographics: large and young labor pool – Low household incomes – Significant structural changes occuring, such as modernization of infrastructure, moving from agriculture to manufacturing and rise of middle class – Above average economic growth – Higher levels of corruption and political risk – Fast growing stock and bond markets – Low levels of wealth accumulation per capita Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 4 Why Emerging Markets are attracting investors? • Growth potential: Emerging economies are expected to grow an impressive two to three times faster than developed nations, according to IMF estimates. As an investor, this is important, because corporate revenues have the potential to grow faster when economic growth is higher. • Diversification: By investing in emerging markets, you help diversify your portfolio, as emerging markets can perform differently than developed markets. • Market Inefficiencies: Another benefit is the potential to discover up-and-coming companies. This is because emerging markets tend to have less-efficient markets where information is not as readily available and there are fewer or less experienced economists and stock analysts. Diligent investors who are willing to research and invest directly in individual companies may be able to find investments with the potential for higher returns. Example: Samsung Electronics • Market Anomalies: Market Anomalies that offer persistent premiums over time to investors are present in these markets. The advantage to sophisticated and experienced investors is that these anomalies can last longer and producer considerable excess returns. Example: Small Cap effect in Emerging Markets Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 5 Factors enabling faster growth of Developing Nations • While there are country-specific differences, compared to developed economies, emerging market economies as a group have: – – – – – – – Young working-age populations: This tends to add to economic growth, while retiree populations generally subtract from growth due to less economic output, higher health care costs and the need for government services. For example, India and Brazil have high ratios of working-age to retired populations. Export strength: Labor costs tend to be lower in emerging markets, driving growth in manufacturing and exports. For example, the Philippines has developed electronics manufacturing and call center industries based on its labor resources. Low levels of government debt: Emerging nations tend to produce more than they buy, resulting in trade surpluses. Large state-owned companies involved in exporting are often sources of government revenues, keeping government debt levels low, and funding infrastructure spending or programs to help raise living standards. Low levels of consumer debt: Debt at the consumer level is also low in many emerging nations. For example, China has strong foreign trade and a low government deficit, as well as low debt levels at the consumer and business level. Growing household income: Rising household incomes afford consumers the ability to have income available for discretionary purchases, resulting in the emergence of a middle-class consumer sector. Indonesia and the Philippines are examples of countries with strong domestic economies and growing consumer classes. Natural resources: Emerging market countries have a disproportional share of natural resource wealth (although exceptions exist, such as Australia, Canada and Norway). Countries rich in natural resources tend to benefit as emerging markets industrialize. For example, Brazil should continue to be self-sufficient in oil over the longer term and has the largest farmable area in the world. Prudent fiscal policies: Many emerging market countries have endured economic crises in the past, instituting strong fiscal discipline well before the 2009 global recession. For example, Brazil has made major strides since 1994, with inflation falling from triple-digit levels to an average of 5.4% over the past five years, and decreasing government debt levels have resulted in an investment-grade credit rating. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 6 Developing Nations overtake Developed Nations: historic shift ! 85% of Mankind living in economies expanding by 4-6% p.a. 19 Developing Nations overtake the Eurozone in share of World GDP – each with 0.4% to 2% weight Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 7 2013-2018: Asia, Africa, Latin America to lead Global Growth, Eurozone becoming less relevant for World Economy 180 170 160 Advanced Economies Euro area 150 Central and eastern Europe GDP Growth indexed to 2012 Developing Asia 140 ASEAN-5 Latin America and the Caribbean 130 Middle East, North Africa, Afgh, Pak Sub-Saharan Africa 120 110 100 2012 2013 2014 2015 2016 2017 2018 Source: IMF Macro Raw Data, Calculations by Ch Takushi MA UZH, 2013 Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 8 Significant changes of global scale Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 9 Emerging Nations affecting and accelerating Global Trends 1. East & South-Shift of Economic & Geopolitical Power 2. Intensifying Competition for Energy, Water, Food and other Resources. Recently also Human Resources (skills) & I.P. 3. Assertive Foreign Policies challenge G7, EU and USA 4. Projection of rising power into U.N. and the Middle East 5. Exporting ever more sophisticated Goods and Military Equipment. Example: Brazil’s Military Transporter beats US and EU’s competitor 6. Social transformation & rise of Middle Class Example: South Korea and Singapore 2 Asian economic miracles Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 10 2. Structure of Emerging Markets – MSCI definition To move up from emerging to developed status, countries need to meet these criteria: 1. Economic development: The country must have income levels 25% above $12,276 (World Bank high income threshold) for three consecutive years. 2. Size and liquidity requirements: The local stock exchanges must have at least five companies with market capitalizations of roughly $1.8 billion each and the amount of trading volume must be significant. 3. Market accessibility: Country must be open to foreign ownership, allow free capital flows, and have stable, efficient markets. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 11 Structure of Emerging Markets: Most advanced in Equity realm GLOBAL EM Countries Brazil Chile China Colombia Czech Republic Egypt Hungary India Indonesia Korea Malaysia Mexico Morocco Peru Philippines Poland Russia South Africa Taiwan Thailand Turkey Total MSCI 12.2% 1.8% 18.5% 1.1% 0.2% 0.3% 0.2% 6.8% 3.0% 14.9% 3.9% 5.2% 0.1% 0.5% 1.1% 1.6% 5.6% 6.8% 11.5% 2.7% 2.1% 100.0% GLOBAL EM Sectors (GICS) Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Total MSCI 11.6% 9.8% 6.4% 8.0% 9.2% 1.4% 27.8% 14.8% 7.5% 3.4% 100.0% Source: MSCI, BCV Asset Management Weights as of Summer 2013 Financial, industrial, technology and auto firms dominate the Emerging Markets Universe: Financials reflect GDP growth, Other sectors reflect massive export growth Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 12 Evolution of Population, GDP & Equity Markets over last 20 years Source: BCV Asset Management, Christian Takushi MA UZH and Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 13 Structure of Emerging Markets: Shrinking Demographics in Developed and large Emerging Nations Source: BCV Asset Management, Christian Takushi MA UZH and Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 14 Structure of Emerging Markets: Emerging Nations have outpaced Developed Nations in Output Source: BCV Asset Management, Christian Takushi MA UZH and Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 15 Structure of Emerging Markets: Both Emerging and Developed Nations issuing more debt Emerging Debt Markets had a late start, but due to EU debt crisis, growth has accelerated Growth in outstanding debt Markets Developed Countries Emerging Countries Frontier Countries Developing Countries Total World Total in Billion USD By end of 1992 By end of 2002 By end of 2012 2002-2012 179% 260% 161% 307% 190% 1'822 7'669 21'919 Source: B.I.S., BCV Asset Management, Christian Takushi MA UZH and Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 16 Structure of Emerging Markets: Some countries dominate Emerging & Frontier international debt Emerging Total Debt, USD Bn (BIS) Frontier Total Debt, USD Bn (BIS) Turkey Argentina Thailand Bahrain South Africa Russia Croatia Poland Jamaica Philippines Kazakhstan Peru Morocco Kuwait Mexico Lebanon Malaysia Lithuania Korea Indonesia Romania India Saudi Arabia Hungary Slovenia Egypt Sri Lanka Czech Republic Colombia Ukraine China United Arab Emirates Chile Vietnam Brazil - 50 100 150 200 250 300 - 50 100 150 Source: B.I.S., BCV Asset Management, Christian Takushi MA UZH and Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 17 3. How to approach Emerging Markets • During 1990’s active investors who dared to enter EM’s early, focused on Fundamental Research & Investing. Heavy focus on company and factory visits => Bottom Up Example: Ekran: limits of company research • During 2000’s institutional asset managers began to apply modern Quantitative Style and Risk Factor Models to enhance return/risk. • Since 2008 with intensified Globalization along rising Systemic & Geopolitical Risks investors are gradually shifting to Global Macro or Top-Down Approaches Quantitative-Fundamental Blend Strategies, Smart Index Strategies and Global Macro Strategies have - individually and combined - added to the sophistication Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 18 4. Characteristics of Emerging Markets: higher risks & costs In addition to the higher growth potential, emerging markets also have higher risks. They share many types of risk with developed markets, but at higher levels. Main specific characteristics are: – Potential for political instability: Emerging market governments can be less stable politically, and events such as external conflicts, coups, and internal tensions can create a difficult operating environment for companies. – Financial conditions: Emerging market countries that do not have sound fiscal and monetary policies are subject to a number of risks. For example, growth can be undercut. Inflation can rear its head—impairing the ability of companies to keep up with input price trends, hurting consumer's purchasing power and potentially destabilizing the country's currency. – Currency fluctuations: There's the possibility that the currency of your investment will fall relative to the US dollar, lowering the return after it's translated back into dollars. In the past some governments restricted repatriation. – Regulatory environment: The rules and regulations of emerging market countries tend to be under development. As a result, market regulation, corporate governance, transparency and accounting standards may not be as reliable or mature as in developed countries. Some countries have restrictions on how freely businesses operate, impacting their ability to earn profits. – Volatility: : Shares on emerging market exchanges can be more volatile and trading can be less liquid. Emerging market investor sentiment can respond quickly to global growth estimates, magnifying performance on both the upside and downside. – Higher costs to invest: Investing internationally normally imply higher fees and emerging markets tend to have higher fees compared to developed markets (often 50% more, but 2x or 3x more is possible) – Data quality: Rather patchy and varies from country to country. Macroeconomic data needs to be evaluated for plausibility. Much higher demands on Data Analysis skills and experience on Economists and Analysts. – Market restriction or exclusion: Some emerging nations forbid foereigners access to some markets (i.e. China) Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 19 Characteristics increasingly driven by large scale effects Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 20 Currency Fluctuations are main financial Risk for investors 130 130 120 120 110 110 100 100 90 80 90 o n 2 0 12 IL S M XN K RW d j f m a m j j a s o 80 20 1 3 B RL TRY E UR O CLP PLN CO P ZAR S ou r c e : T h o m s o n R e ut e r s D a t a s t r ea m Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 21 5. Sovereign Defaults and Debt Restructurings • With sovereign borrowing dating back to the B.C. era, the world has a long history of sovereign defaults and their nasty aftershocks. • There have been already 600 debt restructurings since WW2 alone. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 22 Major Sovereign Defaults and Debt Restructurings 1/2 • Venezuela - July 1998 - Defaulted on $270 million worth of domestic currency bonds • Russia - August 1998 - A massive $72,709,000,000 default that rattled the entire global economy. – The trouble started in August of '98 when the country missed payments on local Treasury obligations, this later extended to foreign currency obligations and MINFIN III foreign currency bonds. Russian debt was eventually restructured in years later. • Ukraine - September 1998 - $1.27 billion dollar default • Pakistan - July 1999 - Defaulted in July of 1999 but quickly resolved the situation • Ecuador - August 1999 - Missed a payment, leading an an eventual restructuring of over 90% of their bonds. Defaulted on roughly $ 6.6 billion. • Ukraine - January 2000 - Defaulted again (1.06 billion) in January of 2000. – Defaulted on both DM-denominated Eurobonds and USD-denominated bonds. Ended up rectifying the situation by exchanging their current obligations for bonds with a longer term structure and lower coupon. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 23 Major Sovereign Defaults and Debt Restructurings 2/2 • Peru - September 2000 - Defaulted on $4.87 billion of debt, but rectified the situation within 30 days • Argentina - November 2001 - A massive $82.26 billion dollar default that rattled the global economy and worldwide markets. – Missed a payment in early 2002 - debt obligations were restructured and the country continued to receive funds from the IMF to aid in their recovery • Uruguay - May 2003 - Argentina's troubles spread to Uruguay, and the government of Uruguay defaulted on $5.7 billion dollars worth of debt in May of 2003. The country eventually completed a restructuring of their debt obligations with their bondholders. • Dominican Republic - April 2005 - Defaulted on $1.62 billion dollars worth of debt in April of 2005. Eventually completed a debt restructuring that ended up extending the maturity of their debt obligations by five years. • Ecuador - December 2008 - Defaulted on $3.2 billion dollars worth of debt obligations after calling several of their previous debt offerings "illegal and illegitimate". An unusual situation in that Ecuador is thought to have the resources NOT to default, but chose instead to default for "moral" reasons. Source: BCV Asset Management, Soufiane Matousi MSc Econ. Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 24 Massive shift into Emerging Debt by foreign investors Many Emerging Local Currency Bond Yields have fallen to levels similar to US and European paper; both sovereign & corporate Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 25 6. Macroeconomic & Geopolitical Challenges i. ii. iii. iv. v. vi. vii. viii. Procrastinating on Domestic Imbalances Deteriorating Demographics & Limited Wealth Accumulation Most at Danger from Unwinding of “Quantitative Easing” “Bubble” in some Emerging Bonds: Flaw of low Debt/GDP ratios Hot Money inflows has exacerbated Corruption USA has regained Global Competitiveness Growth Model via Exports is crowded Asia-Pacific: Region with most unresolved conflicts Over USD 3’900 Bn in military spending over next 10 years ix. Aggressive Foreign Policies by big Emerging Nations has begun to affect Investments and FDI (future GDP growth) x. Global Supply Chain heavily exposed to North East Asia Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 26 Limited Wealth per capita a major challenge 1) Taiwan and Israel among most efficient nations in translating GDP Growth in Net Wealth for its Citizens 2) Some Governments prioritize National Wealth, over Citizens’ Wealth 3) S. Africa, Russia and Brazil with structural problems. China faring better. With deteriorating demographics, underfunded pension systems and poor Wealth Accumulation: rising Risk of political instability. Source: Allianz Wealth Report 2012; Concept of Macroeconomic Efficiency Ratio & Calculations by Christian Takushi MA UZH, 2013 Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 27 Personal Wealth: Excessive Focus on GDP, Neglect of Assets & Debt per capita Macroeconomic Analysis: Growth in Peru-Colombia more sustainable than Brazil’s Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 28 Personal Wealth: Indonesia overtook India, Thailand takes on China Wealth per capita in China & India still at low levels – Excessive focus on “nationwide figures” by financial media Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 29 Demographics of largest Emerging Nations Fertility 1.5 Source: U.N., BCV Fertility 1.9 Fertility 2.6 ë India has what China lacks, but it has not overcome the literacy problem Fertility 1.6 Master en Droit et Economie / Automne 2013 / Prof. F. Alessandrini 30