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By Thomas Connelly
Neoclassical economics posits two types of growth: capital deepening (or capital intensity) and growth from technological innovation. Capital deepening is the amount of capital deployed per worker. Developed markets generally have reached the point of diminishing returns with respect to capital deepening, but emerging economies are far from that point. Both emerging and developed economies can benefit from technological progress. Emerging markets may thus fire on two growth cylinders versus a single source of growth in the developed world.
One definition of economic growth from theory is population growth multiplied by productivity growth. Productivity from emerging markets may be enhanced from deploying more capital as well as technological advances. But from the perspective of population growth, the developed world is at a standstill (indeed, Japan and Italy are experiencing negative population growth), while the emerging world population is still growing, albeit at an accelerating rate.
There is spectacular evidence of potential growth turning into realized growth over the past 45 years. Since 1970, emerging market growth has exceeded developed market growth substantially. Today, emerging market countries account for over 70 percent of growth. Since 1970, faster emerging market growth has resulted in the share of global GDP expanding from 27percent to 50 percent. It will continue to grow faster as a result of higher capital investment (65 percent of the world total) and attendant 62percent share of world commodity consumption. Despite having 87 percent of the world’s population and 50 percent of the word’s economic output, emerging markets’ stock market capitalization is only 12 percent of the value of world stock markets at present.
From a financial perspective, emerging markets were often viewed as a joke, lumped in with banana republics led by dictators or populists, who spent the countries into bankruptcy followed by currency collapses and bond defaults — sounding more like the developed world today rather than the emerging one. Emerging markets experienced a series of economic and currency crises in the 1990s, beginning with the “Tequila Crisis” in Mexico and the Thai Currency Crisis in culminating in the Russian debt collapse. As a result of these crises (and earlier ones in the 1980s), emerging markets recapitalized their banking systems, implemented economic and fiscal structural reforms, and began accumulating large foreign currency reserves to protect themselves. Today, one could argue they are safer from a financial standpoint that the US, Europe, or developed Asia. Emerging markets have only 18 percent of the world’s debt, but 71 percent of world currency reserves. As a result of its 1990s experiences, emerging market banks are well capitalized. There is truly something new under the sun.
A quote from Grants Interest Rate Observer, attributed to David Rosenberg, chief investment strategist at Gluskin Sheff, states, “You can have cheap stocks or good news, but you can’t have both at once.” Good news is indeed what we have in the US stock market at present and in the recent past. But, as the saying goes, “good news, and good stories or narratives, often come with a higher price tag attached.”
Right now, emerging market stocks and bonds are under siege resulting from the restructuring of the Chinese economy and the collapse of the commodity markets. They are in the 4th year of trailing US market returns out of the last five; a very familiar scenario to those who remember the mid and late 1990s.
Notwithstanding the ebullient social media stocks, the biotech stories, and the new era of “fracking”, aggregate pricing in the US stock market looks to be some what average (trailing twelve months price/earnings ratio of 19.5 via Standard and Poors) from recent data and somewhat expensive looking at the Shiller Cyclically Adjusted Price Earnings Ratio at around 27 versus a long run average of around 16 for both averages. The valuation numbers for emerging markets in the aggregate, from MSCI data, currently stand at 10.80 for the Shiller measure and 12.8 using trailing twelve months of earnings.
Considering the amount of fiscal and monetary firepower unleashed in response to the financial crisis over the past six years, and the extremely low interest rate level, this level of valuation seems like a great opportunity.
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