Investors love stories, but no happy ending for Emerging Markets

Investors love a good story, but the latest chapter of the emerging markets growth story has come as a nasty surprise to many. There may be much worse to come. Narratives can help to make sense of facts and figures. Stories can convey meaning, by joining up often unrelated information, and they offer hope. But not all stories have happy endings.

Narratives have intrinsic appeal, and are told by companies to their shareholders, by investors to clients and even politicians to voters. People want to believe. Growth always sounds good, and the concept of lifting poorer parts of the globe into better living standards seems like impact investing. Advocates of BRICS and emerging markets talk much more of belief, and a brighter future, than they do hard numbers. Their faith is not so easily unsettled by mere facts.

Unfortunately, studies suggest there is little link between stockmarket returns and economic growth – at least not any relationship of investment value. Psychology comes into play, where the representativeness bias encourages the belief that a growing economy must mean rising stockmarkets. Yet, even the idea that revenue gains must translate into profits growth is questionable. Developing economies are turbulent environments, with some unique risks to businesses. And that is before political instability, currencies and credit are taken into account.

Even though forecasts are fraught with uncertainty, investors could learn from history. The long term economic record in China, Argentina and India, shows that development is not a straight line exercise. Emerging economies can spend decades dropping down the rankings, often wiping out equity investors.

The record shows previous regional crises – in Asia and Latin America – but rarely a broadly-based pattern hitting all emerging economies. The current crisis has developed slowly, catching many investors unawares. No single economy is overheated, nor is there any clear external shock. A sharp fall might have jolted investors’ faith in emerging markets, and created a fresh narrative about panic and rebound. Instead, economic growth has gradually deflated, along with a slowing of world trade and a fall in commodity prices.

Were it simply a bubble being pricked – an asset overvaluation – investors might have a better understanding of where the floor lay. Instead, it is a creeping crisis of anaemic growth with no clear solution. Should BRICS defend currencies that may really be overvalued? And, does competitive devaluation offer any real solution to failures of productivity or infrastructure investment? Many of these developing nations have failed to create sustainable value-added – a problem highlighted, but not caused, by falling commodity prices.

The one continuing competitive strength that emerging markets had in common was the ability of their governments and corporates to borrow cheap US Dollars. Indeed, this has arguably been the biggest single factor driving the dream. In recent years there has been little limit to leverage and almost no cost. Now, the world is no longer awash with Dollar liquidity, and those Dollars look increasingly expensive to re-pay.

Few BRICS or emerging economies have any policy tools left in their chest. This opens up the possibility of political risk in countries as far afield as Brazil, Mexico, Turkey and South Africa. Even India, with its renewed confidence, has weak credit growth, excessive regulation and outdated infrastructure.

Investors need a new narrative on emerging markets – preferably non-fiction. Their economies have potential for future growth, but investors need to analyse the hard facts of what this means for equities. More thought must be given to politics, deregulation, productivity and realistic infrastructure investments. The emotion of wishing a rise in living standards around the world is laudable, but equity investors must combine this with objective analysis.

A version of this article was published as in the Behavioural Finance Series in Citywire on September 24 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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