Why Emerging Markets Matter

The United Nations estimates the ranks of the global middle class will swell by 2 billion people by 2030, with the bulk of that growth occurring in China, India and other emerging-market countries. Population growth rates in the world’s less developed regions are projected to average roughly five times that of the world’s developed regions over the next 10 years alone. This growth differential is expected to widen in subsequent years, helping developing countries account for more than three-fourths of global GDP by 2050, up from about half now.

This emerging-market explosion has significant implications for the world economy and for investors. We saw some of this at Pittsburgh’s gathering of the Group of 20 nations (G-20) in 2009, where some developing countries were made full partners, thus assuring their place at the table when it comes to shaping global economic policies. While we at Federated have always counseled investors to maintain a diversified portfolio that includes international holdings, the case has never been more compelling.

This Time, History Isn’t Repeating Itself
In some ways, the case for investing in developing countries is enhanced by what has happened in developed countries. One of the ironies of the global financial crisis is that the major developed countries, and not developing countries, emerged in worse shape. It may be a cliché, but until this past decade and particularly the 2008-09 global recession, it has been true: Whenever the Western economies caught a cold, the developing countries got the flu. Their export markets would dry up. Internal demand, never enough to support their economies, would decline. Production cutbacks and layoffs would spawn social and political unrest. Foreign capital would flee, their currencies would plunge in value and inflation would soar. It is a story that has been repeated time and again, from the Latin American crises of the 1980s to the Mexican (1994), Asian (1997) and Russian (1998) financial crises of the 1990s.

But this time around, the global financial crisis was of the developed world’s own making, and it was the developed countries that continue to bear the brunt of its costs. According to professors Carmen M. Reinhart and Kenneth Rogoff of the University of Maryland and Harvard, respectively, private debt exceeds more than 200% of GDP in advanced European countries and nearly 300% in the U.S. This run up—fed by the past decade’s near-record-low interest rates and an explosion in mortgage loan products—is in addition to record public debt that soared the past several years as policymakers adopted massive and coordinated stimulus packages to stem global decline. By comparison, debts—both public and private—are relatively small in the developing world, freeing them to focus on growing their economies and their middle class as the global recovery takes hold.

Fiscal Fitness Helps EM Countries Catch Up
Fiscal budget deficits as a share of GDP stood at 6.6% in advanced economies in 2011, according to the International Monetary Fund (IMF), versus 1.2% in emerging markets. Gross government debt as percent of GDP was 105.5% for advanced countries, versus just 37% for EM economies. For developed countries, there are no easy solutions to the debt problem. Potential fixes—tax increases, spending cuts or both—will likely further inhibit what has been subpar growth if a country is growing at all. Reinhart and Rogoff have concluded that when gross debt-to-GDP ratios exceed 90% for five years or longer, a path the U.S. is on, average annual growth tends to run two percentage points lower than for countries with debt below 30% of GDP. A two percentage-point reduction is hugely significant; had that occurred in the U.S. since World War II, the growth rate over the past 65 years would have been roughly halved.

To be sure, developing countries historically have been more prone to political eruptions and economic crises, and their less-regulated, higher-beta markets have always been more volatile and less liquid. The past few decades are scattered with the remnants of lenders and investors felled by debt crises and market collapses in Latin America and Asia. These concerns are not easily dismissed or forgotten, particularly as concerns mount that the faster growth and surging spending in China and other emerging markets could be creating asset bubbles—and as we witnessed, bubbles can burst at a painful cost.

A Structural and Secular Story
Still, the important role emerging countries now play in the global economy reflects a structural and secular shift that has been building for years. At the core of this realignment process is a significant widening in the growth differentials between the developed and developing countries. Debtladen developed countries are now being forced to deleverage, rebuild savings and restore their balance-sheet health, a process that undermines an economy’s future growth potential because so much of its resources must be used not to build productive capacity but to restore fiscal health. The IMF estimates that financial recessions typically run 1½ times longer than typical cyclical economic recessions, and economists Reinhart and Rogoff note such recessions tend to inflict far more damage than the typical cyclical recession.

At the same time much of the Western world undergoes this deleveraging process, many emerging countries—particularly in Asia and Latin America—are using their financial where-withal to work on building their internal economies to meet the needs of a rapidly expanding middle class. China, for example, already buys more beer, cars and cell phones than U.S. citizens, and the gap is widening. It’s not just China that’s experiencing such rapid middle-class growth. It’s happening over much of Asia, creating a huge demand for resources and commodities that in large part is being fed by commodity- and resource-rich emerging countries in Latin America, such as Peru, Brazil, Argentina and Venezuela. This Asian-Latin American axis is a key force in the convergence between developing and developed countries.

Underleveraged and Undercapitalized
Emerging countries—particularly in Asia and Latin America—also are undertaking massive investments in railroads, telecommunications, roads, ports, airports, power stations, and water supply and sanitation systems to accommodate their booming population and urbanization. India alone is planning $1.7 trillion of such investment through 2020, and office and residential construction has surged in China, where it is expected that 350 million more people will move into its urban centers by 2025, a number that easily exceeds the current U.S. population. Overall, the U.N. predicts 1 billion new dwellings will need to be built by 2020 to accommodate developing countries’ growth, with 90% of the supply going up in emerging markets.

The economies of emerging countries are projected to continue to grow at nearly triple the pace of the developed world. And emerging countries have the capacity to grow. Their debt levels are comparatively low, many of their working-age populations aren’t expected to peak for another 10 to 20 years (they already have in the developed world) and their ability to generate their own capital has never been higher. Still, even with a growing pool of internal financial resources, their growth is expected to outstrip their ability to finance themselves on their own. Emerging markets are considered undercapitalized, under-owned and under-leveraged, creating attractive investment opportunities. 

As Gap Narrows, Opportunities Widen
This is good news for investors and the U.S. economy. Confronting a highly leveraged consumer and government, the country must turn elsewhere for growth, and for the foreseeable future, much of that will come from emerging markets. President Obama’s push to double exports in five years reflects the reality that, unlike U.S. consumers and federal, state and local governments whose ability to spend and grow will be hemmed in by the buildup of debt on their balance sheets, the potential for growth in exports is limited only by the competitiveness of U.S. goods and services and the global appetite for them. And that appetite, increasingly, is coming from emerging markets. In 2012, Mexico, China and Brazil were the second, third- and 7th-largest markets for U.S. exports.

Similarly, for investors who take a long-term view, emerging markets offer potentially historic opportunities. While developing countries already account for about half of global GDP, they still represent less than a quarter of global market capitalization, a gap that is likely to move toward a better balance as developing and developed economies converge in coming years. For all the concerns about political upheaval, volatility and crises, emerging-market countries already have exhibited staying power. Over the last 10 years, emergingmarket equities and emerging-market fixed income assets provided greater returns than their U.S. and international counterparts, according to Morningstar. It would seem that, now more than ever, the case has never been stronger for a diversified portfolio to include emerging markets.

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