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Growth advantage over mature markets has halved and is set to disappear

The 2018 annus horribilis has put emerging market assets in a competitive situation: they are undervalued both historically (with equity price/earnings and price/book ratios below their 2000-18 averages and currencies undervalued) and relative to their mature market counterparts (especially offering higher real yields).

EM assets are still underweighted in global portfolios. As such, EMs are in a good cyclical position to recover when the global growth outlook stabilises, adjusting to the new normal of ongoing trade and political tensions.

Beyond this near-term view, however, the long-term case for diversifying into EM assets needs to be recalibrated, because many EM countries are faced with growing structural headwinds. Basically, they reflect a premature “ageing” of EM economies.

Most important is the ageing of many EM populations, albeit from a younger age structure than in mature markets. According to UN projections, the old age dependency ratio in EMs (65+ over the working age population) will rise from about 10 per cent at present to more than 22 per cent by 2050; the comparable increase in mature markets is from 28 per cent to 45 per cent.

In particular, except for India and Africa, EM labour force growth has slowed and actually declined in countries such as China (thanks to its one-child policy).

In addition, productivity growth has shown signs of resuming its earlier trend of slowing since the 1960s after a recovery in the early 2000s. According to the IMF, for EMs excluding China, total factor productivity growth decelerated from about 2.5 per cent a year in the 1970s to minus 1 per cent in the early 1990s, then recovering to almost 1 per cent in the early 2010s before slowing down again.

Similarly, labour productivity growth recovered strongly from the early 1990s to more than 3 per cent, driven by a quickened pace of capital accumulation thanks to low financing costs, but has recently shown signs of topping out.

Besides factors such as reform and capital deepening, which can promote productivity growth, other factors exert a negative influence on long-term productivity performance — such as the premature deindustrialisation in many EMs and developing countries.

In recent decades, the share of manufacturing employment and value added in those economies has peaked and declined earlier in their development process and at lower levels of per capita income. This is in comparison with their own performance before the 1980s and especially relative to the experience of mature markets. To the extent that manufacturing activity and jobs tend to exhibit higher levels of productivity, the premature relative decline of manufacturing in favour of the service sector (which has grown to more than 53 per cent of GDP from 45 per cent in the 1990s) can dampen overall productivity growth.

Interestingly, modern technological changes can both help promote inclusive development in EMs (for example, in the case of the M-Pesa mobile payment system in Kenya) but also hinder their industrialisation efforts by emphasising trade in services and intangibles at the expense of manufacturing for export, which had been the main route for the industrialisation of the East Asian Tigers and China.

Such a shift into services, whose share of total exports rose from 17 per cent in 1979 to 24 per cent in 2017, can amplify the negative impact of rising protectionism on world merchandise trade, where EMs have a higher share (44 per cent) than in services (34 per cent). In addition, some major countries such as the US try to unwind global supply chains, preferring automation at home to (less) cheap labour overseas — thus also cutting back on trade in intermediate goods. Overall, a continued slowdown in world trade will weaken a key motor of growth for many EM countries.

Altogether, those trends combine to lower the EM potential growth rate. Indeed, after a growth spurt of more than 6 per cent a year in the first decade of the millennium — driven by a wave of reforms adopted after earlier financial crises in Latin America, Asia and Russia — EM growth has slowed to about 4.5 per cent at present.

In part, this reflects the exhaustion of the benefits of earlier reform measures — such as the adoption of more flexible exchange rates, inflation targeting, reserve accumulation and efforts to improve fiscal sustainability including some pension reform — while the pace of additional reform has stopped or even reversed as reform fatigue sets in. In the long run, according to the OECD, the potential growth rate of the Briics (Brazil, Russia, India, Indonesia, China and South Africa — accounting for most of EM GDP) is expected to slow further, converging to mature market trend growth of 2 per cent.

In other words, the growth advantage of more than 4 percentage points that EMs enjoyed over mature markets in the 2000-2010 period has narrowed to about 2 percentage points and will probably disappear in the long run.

This potential growth slowdown puts the recent increase in EM debt in a more worrisome light. Debt has risen to a record amount of $71tn in the second quarter of 2018, according to IIF data. While government debt for EMs as a whole is relatively low at 48 per cent of GDP (compared with 109 per cent in mature markets) several countries such as Brazil and Hungary have high levels of government debt. More concerning is non-financial corporate sector debt, which at 95 per cent of GDP is higher than in mature markets (91 per cent).

Such high levels of outstanding debt, especially in light of rising financing costs, will make it more difficult for EM corporations to incur sufficient new debt to sustain investment and growth. This is particularly the case as it now takes more debt to produce the same amount of growth than before.

Moreover, the current EM debt burden will make it more difficult to fund and build up pension assets to provide for future retirees. Except for South Africa and Chile, most EM countries have very low levels of pension assets in funded and private pension schemes — less than 25 per cent of GDP, which is much less than countries such as the UK (77 per cent) and the US (118 per cent). This will put pressure on public “pay-as-you-go” pension systems in EM countries, especially if government deficits and debt cannot be brought under control.

Ultimately, failure to adequately provision for future retirees can create social tension, not conducive to growth.

In conclusion, the case for global investors especially pension funds to diversify into EM assets (younger population, higher growth and potentially superior return) is still reasonable for the foreseeable future. However, in the long run, this case depends critically on whether policymakers in EMs can implement appropriate policies to tackle the structural problems mentioned above, to improve productivity and foster inclusive growth.

In this race, some countries will do better than others. Hence, the key in EM investing is to be selective in picking country and stock exposures — and not treating EMs as a homogeneous bloc. After all, for 2018 the dispersal of US dollar-adjusted returns among different EM equity markets is much wider (48 percentage points, between minus 54 per cent in Argentina and minus 6 per cent in Russia) than between the MSCI World and EM indices (5 percentage points).

Erosion in support for bodies ranging from army and church to trade unions and police

Germans are losing trust in their country’s social institutions, according to a new survey that highlights an unusually broad erosion in support for bodies ranging from the army and the church to trade unions and the police.

“We have been asking Germans for more than a decade how much trust they have in relevant social institutions. Never before have we seen such an across-the board decline as we measured this year,” said Manfred Güllner, the director of the Forsa polling group, which published the survey on Monday. 

Of the 26 institutions featured in the survey, 22 showed a decline in public trust. Germany’s armed forces, the Bundeswehr, performed particularly badly, suffering a year-on-year fall of 13 percentage points. Schools declined by 10 percentage points. The police were once again the most-trusted institution in the country, but fell 5 percentage points compared with last year. 

A Forsa poll looking at the level of trust in political institutions such as parliament and political parties will be published next week, but Prof Güllner said the trend was broadly similar. “The great majority of political institutions has also seen a fall in trust.” 

Some of the findings from Monday’s poll are likely to reflect the fact that the affected institutions came under especially sharp scrutiny and criticism in 2018. The Roman Catholic church, for example, made headlines repeatedly in connection with sexual abuse scandals. It saw a 9 point decline in trust while the pope’s rating fell 20 points, the biggest decline of any institution measured in the poll. 

Germany’s military, meanwhile, drew frequent negative publicity over the past year, amid reports detailing the underfunding of the armed forces and the poor state of its equipment. A 2018 parliamentary report noted that the Bundeswehr was in “dramatically bad” shape, pointing out that critical weapons systems such as submarines and transport aircraft were at times unusable. 

Germany’s schools have also been exposed to extensive critical coverage in recent years, most notably for the poor state of their buildings and general infrastructure and — at the end of last year — in connection with a political row over how best to equip students with digital tools. 

“There is a general sense that things are not working as they should,” said Prof Güllner. “According to everyday experience, it seems that problems are piling up and that the state has lost control over many of these areas.” 

The loss of trust was particularly marked among supporters of the far-right Alternative for Germany, according to the Forsa poll. Only 13 per cent of AfD supporters said they trusted the press, for example, compared with 41 per cent for the broader population.