Arrested Development

BRIC Fix

Until recently, consensus held that the rest of the world could decouple from a U.S. slowdown. However, given that both the Eurozone and Japan registered negative growth in the second quarter, expectations are rapidly changing.

Brazil, Russia, India and China (BRIC) now represent 15% of global output and roughly 50% of the MSCI EM Index. The BRIC equity markets have performed well over the past seven years, returning roughly 17.9% (in Canadian dollars). But this year, as of Aug. 27, 2008, they have fallen by 24%, underperforming emerging markets as a whole. Per capita income has been growing very rapidly in the BRIC countries in recent years, especially in Russia and China. Furthermore, the rise of domestic demand has exerted a powerful influence on global commodity prices and economic activity. For example, each of the BRIC countries faces massive needs to increase electricity generation capacity. Last year, China installed the equivalent of the entire installed electricity generation of the U.K. in just 12 months!

As global growth slows, the BRIC countries face a series of common challenges as well as country-specific issues. One challenge that they share is curtailing inflation and inflation expectations. Recent year-over-year Consumer Price Index increases in the BRIC countries are uncomfortably high: 6.4% in Brazil, 14.7% in Russia, 7.7% in India and 6.3% in China. Rising food and energy prices have contributed to the recent inflationary impulse. But there are also other factors such as exchange rates that are not fully marketdetermined, as with Russia and China.

Sustained high rates of inflation tend to lower price-to-earnings ratios, raise the returns required by investors, distort reported earnings and depress real economic growth. At 10 times 12-month forward earnings, emerging market equity valuations can hardly be deemed very expensive, even if the expected 12-month earnings growth of 17% disappoints. But for emerging markets—and the BRIC countries, in particular—to mount a sustained rally, global investors will have to be convinced that global and regional inflation will fall and the world will avoid a recession.

Investor Expectations

Over the next several months, emerging equities will be hostage to expectations about the future path of the world economy (and, by extension, global earnings), global credit markets and inflation prospects. A key factor is development in China, now the world’s fourth-largest economy. The Chinese economy is expected to grow in excess of 9% next year, according to consensus forecasts, but risks are to the downside. The 20% fall in emerging market equities this year (as of Aug. 26, 2008) reflects investor apprehensions.

The underlying drivers of globalization remain intact—particularly the ongoing technology and media revolution—but the rise of economic nationalism in resource-rich emerging markets and the stagnation of real wages for large segments of the U.S. population over the past eight years may lead to increasing tensions in the governance of the world economy in the years ahead. Evidence of these tensions includes the collapse of the Doha trade round; the explicit promise of the Obama campaign to renegotiate NAFTA; the desire of Russia to promote “national champions”; and the ambivalence expressed by Angela Merkel and Nicolas Sarkozy about potential acquisitions in Germany and France, respectively, by sovereign wealth funds (SWFs). Additionally, Russia’s invasion of Georgia has created substantial tensions with NATO and the EU.

Future Prospects

Emerging markets represent roughly 11% of the world’s investable market capitalization. The current global financial crisis has led—and will likely continue to lead—to tighter financial market regulation and government intervention in the economy. Systems that are perceived to socialize losses and privatize gains are susceptible to attack. Therefore, finding the right regulatory balance will be a major challenge for the next U.S. administration. Despite their increasing resiliency to shocks, prospects for emerging markets in the longer term continue to be inextricably tied to a healthy U.S. economy.

It would be a mistake for investors to abandon their strategic commitment to emerging markets at a point of stress in the world economy. There are large and growing pools of liquidity, such as SWFs, which will increasingly look for return streams that exceed cash and bonds. At the same time, the tendency of global equity markets to revert to a global mean implies that emerging market and developed market returns may converge in the years ahead.

George Hoguet is a managing director, senior portfolio manager and global investment strategist specializing in emerging markets with State Street Global Advisors. george_hoguet@ssga.com

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