We discuss how emerging markets are racing to implement structural reforms and the challenges and opportunities this presents for investors.
Election victories for reform-minded leaders such as Modi and Widodo represent an important turning point for many emerging markets. Source: Wikimedia
The Great Financial Crisis of 2008 laid bare the inadequacies of the social-democratic capitalist model across many Northern Hemisphere nations. Their economies had over-burdened themselves with debt, their markets had encumbered themselves with regulation in all areas aside where genuinely needed, and their policy makers had become complacent. New models for the provision of healthcare, welfare, pensions and university education needed to be developed. The race against resource misallocation, overbearing regulation and policy sclerosis is by no means won in the developed world, but it’s increasingly one being taken up in the emerging world too. For the likes of Widodo and Modi, their elections represent not only the opportunity to rescue their respective countries from the economic malaises they have fallen in to, but also to ensure that their paths to development don’t repeat mistakes that have been made elsewhere.
Realisation of this necessity and opportunity for reform makes it a fascinating time for the investor in Emerging Markets. But it would be naïve to assume that the reformist tendencies burn with the same intensity everywhere – our first challenge as investors is to determine those countries making decisively forward steps from those who eschew the painful decisions. To this extent we are greatly cheered by the new governments of India and Indonesia. Modi has made clear his determination not to squander India’s demographic dividend and encourage foreign participation in manufacturing, retail, insurance and defence. India, a country where just 1 in 5 is a regular wage earner, has some of the most stringent labour regulations in the world. To make the leap from field to factory requires not just liberalised FDI but also reform of the labour market – Modi’s prioritisation of legislative reform in this area gives most cause for optimism.Widodo’s in-tray overflows similarly; a need to cut the food and energy subsidies which account for one fifth of the government’s budget, a swollen current account deficit and a decade of underinvestment during which spending on infrastructure at 3-4% of GDP has been half of even India. His focus on securing inward investment from the likes of Korea and Japan, upgrading the country’s ports and infrastructure, and improving human capital through the expansion of his Jakarta school and healthcare card program is deeply encouraging.
Beyond Asia we see similar patterns of states responding to the wake-up call of the GFC. Most obviously, Mexico has made vast strides under Peña Nieto, with Congress passing 11 structural reform bills in just the last 20 months, including a $600bn infrastructure plan. The most recent bill, which ends Pemex’s monopoly within the energy sector, has the potential to be truly transformational for Mexico. Colombia has become the fastest growing large country in South America, in part thanks to reforms that introduced a fiscal rule to safeguard the public balance sheet, as well as significant investments in infrastructure. Kazakhstan’s massive investment in overseas scholarship programmes for its brightest students is already paying dividends through the quality of graduates returning. The tiny nation of Georgia has catapulted itself to 8th in the World Bank’s Ease of Doing Business ranking through a series of market friendly reforms which have made it the envy of the region.
Yet strong performance of emerging equity markets is not a necessary corollary of the aforementioned reformist momentum. Firstly, there is clearly a strong interplay between market expectations and the pace of reform delivery.
Indian stock market has substantially outperformed in expectation of reform
India rel to MSCI EM
Source: TT International, Bloomberg
Markets have responded well to Modi and Widodo, but further outperformance will be dependent on translating their undoubtedly positive message into bills on the statute book. Whilst Modi has a strong parliamentary advantage, Widodo enjoys neither the same personal mandate with just 53% of the vote nor a parliamentary majority. Mexican assets have similarly performed strongly, but there at least we have certainty over the government’s delivery. Reconciling the ambition of reform, the capacity to deliver it and the opportunity at hand is the challenge for the investor. Secondly, the notion that reform is a teleological process across all Emerging Markets is one disproven by history. Pension reforms in Poland and Russia both appear as backwards steps which harm the flourishing of a non-state sector. The perennial failure to tackle labour reform in South Africa is a grave, missed opportunity.
So, if markets are swift to price in reform potential, often well ahead of its execution, staying on top of the next market to reform is crucial. With this in mind, Brazil and China have been at the forefront of our thinking this year. We believed that defeat for Dilma Rousseff, priced as a distant prospect at the start of 2014 by the market, was a decent possibility – as of now the market sees it as too close to call.
Polls show Marina Silva is currently neck and neck with incumbent President Dilma Rousseff. Source: Wikimedia
The opportunity to challenge endemic under-investment, protectionist trade policies and the resultant persistently high inflation is considerable. Chinese state owned enterprise reform initiatives appear tentative thus far but again have the potential to light a fire under the market, particularly if better allocation of capital is genuinely pursued as a goal.
Emerging markets are responding to the challenges presented to them and reimagining the role of the state in the post-GFC world. States are seeking to become leaner, more dynamic and are more comfortable with allowing market economics to allocate resources. Yet this trend is not uniform – successful investment in Emerging Markets requires not just the selection of good companies, but allocation to the correct markets at the right stage of their reformist drives and when this reform is still underpriced. Whilst still watching for delivery from Modi and Widodo, we are eagerly anticipating who next will pick up the reformist baton.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).