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Éric Morin, senior analyst at CIBC Asset Management.
The macroeconomic forces that will make emerging market classes more attractive over the long run, are stronger trend growth and the sign that they have become less riskier than in the past. Economy growth in emerging economies will remain relatively better owing to smaller policy renormalization headwinds and tailwinds from the ongoing convergence of living standards toward those of advanced economies. This simply means higher interest rates and better profit growth over the long run for emerging market economies as a whole.
On monetary policy renormalization, the drag on economy growth will be much smaller in emerging economies than in most advanced economies because policy rates of central banks are less below their respective long-run natural rate.
Let me explain. A neutral rate is the policy rate at which an economy can grow at it’s potential pace without generating financial or inflation imbalances. Over the long run central banks will [have] to increase their respective policy rates to their neutral rate. For central bankers in developed economies where rates are extremely low, higher policy rates will be needed to cope with potential future economic downturns and to prevent any or further buildup in financial imbalances associated with too low for too long interest rates. The bottom line is that policy renormalization of central banks will hurt much less emerging economies because rates are much less below the neutral policy rate.
Another reason why renormalization will hurt less [for] emerging economies is the fact that they have smaller debt loads as a share of GDP, simply meaning smaller deb-servicing burden for consumers and government following a given increase of interest rates.
Another reason why growth in emerging economies will continue to outperform is the process of growth catch up under which living standards of emerging economies with continue to converge toward those of advanced economies. This process has been historically a key driver of economic growth divergences. For example, more than a century ago, living standards in North America were still moving toward those of the U.K. and Western Europe. This process of convergence had resulted in superior economy growth in North America.
While this process of convergence of living standard has remained for emerging economies it has in fact gathered momentum in the last decade. Now GDP per capita in developing in emerging economies now account for about 40% that of advanced economies, a proportion about twice larger than a decade ago.
The second reason of the relative attractiveness of EM economies and EM financial assets is the fact that their economies have become, as a whole, less risky than in the past. The main reason for that is a more diversified economic growth mix. Like a financial asset portfolio, the more diversification you have the less idiosyncratic risk you take.
As a whole, emerging economies have made considerable progress in transitioning away from excessive reliance on exports and commodities. Reflecting this the tertiary sector dominates emerging market equity with a share of about 70%, similar to that in developed markets on average.
The more diversified growth mix helps with their current account vulnerabilities and, along with the effects of the implementation of many structural reforms, paves the way for sustainable long-run macroeconomic performance and provides as well better resilience against negative macroeconomic shocks such as increasing interest rates.
Another reason why emerging market economies have become less risky is the new Phillips Curve in the U.S. A Phillips Curve is the relationship between inflation and labour-market tightness. In the past the sensitivity of inflation to labour market was much higher when labour markets were tight. The consequence was that the Fed had to tighten considerably [its] monetary policy with higher rates, which resulted in important capital outflows outside emerging market economies. This relationship between inflation and labour markets has weakened considerably over time meaning that the Fed is less likely to tighten aggressively its monetary policy—meaning that emerging market economies as a whole are less at risk of experiencing an outflow of capital following an aggressive tightening path by the Fed.
However, there’s significant divergences that remain across emerging countries. Countries like Argentina or Turkey are still quite vulnerable to shocks. While these represent a very small weight in the equity and bond universe, vulnerability tends to grab headlines and attract most of the attention. On the other hand, other emerging countries such as South Korea could now be considered more developed than some of the smaller developed countries such as Portugal.
The cause behind this trend is the fact that there’s been a rapid convergence of living standard in South Korea. For example, two decades ago, GDP per capita in South Korea adjusted for purchasing power parity was about 25% below that of Portugal, but things have changed. For example, today GDP per capita in South Korea is about 30% larger than in Portugal. In fact, what has been going on in South Korea is more than growth catch up. South Korea has simply out paced many advancing economies by becoming better and more competitive at producing high value-added goods.
The takeaway there is that many EM economies are slowly becoming advanced economies as well. From a macroeconomic perspective, many of them are under a sweet spot: they are still having economic growth outpacing that of developed economies because of the catch up of living standard and, on the other hand, they have become less risky over time. The bottom line there is that this has contributed to make several EM more attractive from a risk-return perspective.