Monday, April 1, 2013

Breakout Nations: Investors Have to Pick Winners

Ruchir Sharma, who heads up Morgan Stanley Asset Management's Emerging Markets efforts, has written a thought-provoking book for investors and economic analysts called, "Breakout Nations." I'm basing this post on reading the book and on an interview Sharma gave with Professor Robert Wade of the London School of Economics.

2007 was the best year for investment returns from emerging markets, capping off their best decade as an asset class.  Sharma says that the macroeconomic foundations of this outperformance were provided by the easy money policy of the Greenspan Fed, a global commodities boom, and the "financialization" of commodity markets.  Of course, these three  turbochargers can't sustain superior returns against the prior periods.

The overarching premise of the book is that during the decade ending 2007, an investor could have bought almost any emerging stock market or an emerging market index fund and achieved market-leading returns.  Going forward, country allocation, in addition to company selection, will be critical for investors looking for superior returns.  The potential winners in the coming decade may not include the choices trumpeted in the financial press.

In the book, Sharma describes his personal research process when he visits a country.  He meets with a wide variety of non-financial and non-corporate, and non-governmental people, including movie stars, sporting celebrities, and the luxe consumer classes about which so much is written.  He takes auto journeys away from the corporate islands and metropolitan centers.  As he paints his mosaic, he then uses this to challenge the quantitative, financial analyses of Morgan Stanley's analysts and portfolio managers,  He uses these economic travelogues to frame a 3-5 year economic cycle for each emerging market, incorporating the data produced by his analytical organization.

In 2010, money flows into emerging markets were massive, and countries like India recorded record investment inflows.  Of course, the macro drivers included the Bernanke Fed's policies that drove investors to take more risks in order to generate their required rates of return from financial assets. Around this time period, the Economist magazine featured several cover stories about the Valhalla of emerging markets for investors in developed countries.

Of the approximately 180 countries, excluding failed states, 35 are developed market economies, and the rest are either emerging markets or frontier markets, according to Sharma.  Looking at cycles of economic growth, he says that economic growth and stock market performance is never an unending, upward trend line; it is more like a game of Snakes and Ladders.

He cites the probability of a country experiencing GDP growth of 5% per annum or better for a decade as being one in three.  The odds of a fast growing decade being followed by a similar growth decade, he says, is one in four.  The probability of a third consecutive growth decade drops to one in ten.

The literature is filled with linear extrapolations of growth that appear naive and foolish, ex post. Sharma cites the IMF's forecast that the world's developed economies would now have welcomed Brazil, the Phillipines and Sri Lanka.  Going a bit farther back, Sharma cites a projection by Nobel Laureate economist Paul Samuelson that Russia would overtake the U.S. in terms of the size of its economy.  Those are some really lousy forecasts!  Warning: treat all long-term economic forecasts with a great deal of skepticism, as they will be hazardous to your wealth.

So, looking back, what were the real breakout nations?  South Korea and Taiwan.  Both countries have grown their GDP at an average annual rate of 5% for five decades.  For other emerging market stars, the 1980s and 1990s provided global market headwinds, like the '94 Mexican crisis, the '97 Asian crisis, and the '98 Russian crisis.  During these periods, Sharma says, emerging markets as a group average slightly above 3% GDP growth.

Russia, which has experienced GDP growth rates of 7% is seeing forecasts ratchet down to the 3% level.  In terms of the Billionaires Index, something cited by Sharma, Russia is number two behind the United States, despite the fact that its economy is relatively small by global standards.   There has been relatively little churn in the composition of the Top Ten, something which Sharma sees as a negative indicator for the future.

A static composition of the top tier suggests a lack of innovation, a concentration of power, and the suggestion that wealth is created and maintained by preferential connections to the government.  In the case of Russian oligarchs, this is a truism.  Aside from the Russian natural gas  hammer being applied to Western Europe, there appears little to underpin a strategy of strong economic growth in the coming decade.

India has had no churn among its top billionaires.  Sharma sees a widely held perception during his visits to India that the populace sees the blessing of the Central government as being the key to economic success.  He goes as far as saying that this feeling about big business being in bed with a corrupt government is what fuels sometimes violent popular movements like the Naxalites.  China and Korea, by contrast have high degress of churn in their top ten billionaires and millionaires.

China has experiences average annual growth rates of GDP of around 10% for three decades.  It is on its way to becoming a middle income country, and he says that the narrative of the "disappearing Chinese consumer" is a myth.  He also says, however, that the IMF forecast of future GDP growth of 8% is probably unlikely.  China's chances of moving into to the top tier of developed economies is around 50/50 due to the often discussed economic, political, and financial imbalances within the economy.

Brazil has used its riding of the commodity booms of past decades to create a welfare state, and a corrollary has been the almost total neglect of internal infrastructure, which we have alluded to in a previous post about global food production.  Sharma's outlook for commodities in general is bearish going forward.

The overriding influence is China's growth rate, which is slowing, as has its demand for raw materials, including for strategic stockpiling, as for rare earths.  In addition, markets have developed substitutes for certain key materials and reduced the resource content for key manufactured goods.  China's demand accounted for 30-60% of global raw material demand for certain commodities when its economy was growing at 10% per annum during its construction boom decades.  All of these trends, Sharma suggests, are reversing.

The availability of capital from global banks, he says, is drying up compared to prior decades. Fiscal issues will be difficult for some economies, e.g. India were growth is slowing, rural wage inflation is rising, food prices are increasingly volatile, and the current account deficit is large and growing.

Sometimes Sharma's interviews lapse into a journalist's superficiality, but there's no doubt that he's put together a very readable book, identifying food for investor thought.

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