Two controversial departures of high-ranking technocrats in the space of three days, one in Ankara, the other in Mexico City, have served as reminders of the high-risk nature of investing in emerging markets.
The dead-of-night sacking last week by legally-dubious presidential decree of Murat Cetinkaya, governor of Turkey's central bank, was followed by the shock resignation of Carlos Urzúa, Mexico's finance minister, who slammed the door on his way out with complaints of cack-handed meddling by unqualified apparatchiks.
Markets were immediately roiled. The Turkish lira and Mexican peso fell more than 2 per cent against the US dollar and analysts warned of disarray ahead, jeopardising economic growth and the ability of borrowers in both countries to repay their debts.
For veteran investors, this may look like routine turbulence in markets where the prospect of fast economic growth has always gone hand in hand with political risk. But the basic calculations are changing for emerging markets as that growth potential dims — and with it, part of the core rationale for investing in the asset class.
Starting in the early 1990s, globalisation, in the form of increased cross-border trade, the commodities supercycle and the rise of global supply chains drove the emerging world inexorably — or so it seemed — along a path of convergence with the developed world.
For many investors, emerging markets became a core part of their portfolios because they offered strong returns and faster growth as the emerging world caught up.
Hundreds of millions of people were being lifted out of poverty and into the consuming classes, offering new opportunities to local and foreign companies. Investment in factories, roads, ports and other infrastructure promised to keep the momentum going.
But convergence is no longer assured. Today, high commodity prices are a fading memory. Trade is stuttering and global supply chains are being disrupted. Far from catching up with the developed world, many supposedly emerging markets are growing more slowly.
As globalisation risks going into reverse, many investors are asking what, if anything, will drive the asset class in future, raising questions over the role of emerging markets in a diversified portfolio.
"The entire rationale [for investing in emerging markets] has been exports and consumption," says Bhanu Baweja, chief strategistat UBS and an emerging markets specialist. "People came into our industry at a time of hyperglobalisation. But now globalisation is flattening, not just because of [Donald] Trump, but for deeper, organic reasons."
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For two decades after the creation of the benchmark MSCI Emerging Markets equities index, EM stocks tended to outperform the S&P 500 index of leading US stocks by a wide margin. For most of the past decade, however, EM stocks have stagnated, while US stocks have more than doubled in value.
The threat to globalisation is one of three big changes simultaneously hitting emerging markets. The second is a slowdown in the rate of growth in China. The third is a change in global financial conditions after a decade of easy money.
The talk of deglobalisation has come to a head in the trade war between the US and China, the latest manifestation of what the Bank for International Settlements last month called a "political and social backlash against the open international economic order".
While many emerging economies may be able to draw on longer-term advantages such as demographics, in the short to medium term the challenges for some threaten to be overwhelming. Argentina is one example. As its government struggles to recover from a crushing recession, "the great question is whether [the country] is ever going to grow again", says Ignacio Labaqui of Medley Global Advisors. Brazil's economy, once the darling of emerging market investors, has suffered recession or mediocre growth for nearly a decade.
The risks are not shared evenly. Indeed, the fortunes of emerging economies have become so varied that many investors question the logic of talking about "emerging markets" at all. It is a disparate group, barely recognisable as the asset class of the 1990s and early 2000s, when a crisis sparked in one corner of the emerging world would spread like wildfire to the rest.
In the past three decades, many countries have embarked on monetary and fiscal reforms, building firebreaks against flare-ups elsewhere.
The result was clear during the sell-off that emerging markets witnessed last year. As the US dollar unexpectedly strengthened, prompting many investors to pull money out of emerging market assets, those countries with weak defences, especially Argentina and Turkey, were badly burnt, while others escaped relatively unscathed.
Nevertheless, emerging economies remain bound together by their vulnerability to the changes under way, and in their need to find a route to growth beyond the trade and global manufacturing supply chains that have sustained them so far.
"The idea that a developing country can take manufacturing from the US and still have access to the US market is not so certain in the new world," says Brian Coulton, chief economist at Fitch, the rating agency.
Shifts in the pattern of globalisation have not been bad for all emerging economies.
Vietnam, for example, has been a winner as multinationals shift production from China in search of cheaper labour and, over the past year, to avoid the Trump administration's import tariffs on goods made in China. Hanoi's luck may not last, however: Trump called Vietnam "the single worst abuser of everybody"before last month's G20 summit in Osaka.
But companies are not simply reallocating resources around the developing world. Foreign direct investment into emerging markets as a whole fell last year to its lowest level since the 1990s, according to the Institute for International Finance.
"This is where I start to worry about emerging markets in a fundamental way," says Robin Brooks, the IIF's chief economist. "Over the past 20 years a lot of manufacturing has moved to EMs to arbitrage wage differentials. That wave has run its course."
In fact, growth in emerging market economies has been falling behind expectations for a number of years. Leave aside the population giants of China and India and, in per capita terms, emerging markets have been growing more slowly than developed economies since 2015.
In terms of productivity gains, too, developing countries have disappointed. Since the mid-1990s, the contribution of productivity to output growth in EMs other than China has been no greater than in developed markets, except for the few years before the global financial crisis when the commodities supercycle was in full swing. It was also during those years that China benefited the most from productivity gains, as technology transfer accelerated following its accession to the World Trade Organization in 2001.
That period looks increasingly like an anomaly. "We don't find much improvement in productivity in the large emerging markets in recent years," says Coulton at Fitch.
Indeed, he adds, growth in the developing world is attributed not to productivity, but to demographics and investment. But while populations keep growing, investment has also now lagged.
"Increasing [the ratio of] investment to GDP is a really big challenge for emerging markets," he says. "This has been China's story for the past 30 years — it has invested much more and grown much faster. It's not rocket science."
The significance of Chinese growth to the broader emerging market asset class is hard to overstate.
"China is the father of global growth," says Baweja. "The last three growth cycles — 2009/10, 2012/13 and 2016/17 — were all born in China. They may have matured elsewhere but they were born in China, of the same cheque book — the Chinese consumer and government."
But the pace of growth in China, too, has been slowing since the global financial crisis.
Not only that, its growth has become less dependent on imports from other developing countries.
When it was driven by investment in infrastructure, China's hunger for iron ore, copper and other inputs was a godsend for commodities exporters — from Brazil and Chile to Nigeria and the Democratic Republic of Congo. But Chinese investment has fallen, from the equivalent of 48 per cent of gross domestic product in 2011 to less than 45 per cent since 2015. Meanwhile, investment is moving towards services and other less commodity-intense activities.
There are also potential risks to China's economic stability. Non-financial-sector debt, for example, has ballooned. It was equal to about 135 per cent of GDP before the global financial crisis, according to the IMF. It rose to about 170 per cent in late 2011 as the government responded to the crisis. By the end of 2016, after government stimulus flowed again, it had swelled to about 235 per cent of GDP.
David Spegel, founder of bond market consultancy Fundamental Intelligence, says China has accounted for 42 per cent of all corporate bond issuance in the emerging world this year. "China is one of the big risks," he says. "As the economy matures, the ability of the authorities to have an impact is not what it was".
At the same time, credit is losing its power to drive growth. Since the 2000s, the amount of capital needed to generate each unit of Chinese output has risen by more than two-thirds. Yet the relationship between credit and growth — China's "credit dependency" — is as strong as ever. The US-China trade war is an added aggravation.
The outlook for China has become more uncertain just as changing financial conditions have added to the challenge for emerging markets. Many investors had expected to benefit from a weaker dollar in 2019, but it has not worked out that way. Last year, the US Federal Reserve began to tighten monetary policy after a post-crisis decade of expansion.
This year, however, it has signalled its willingness to cut rates again amid signs of economic weakness. And in an environment of weak global growth, investors tend to prefer the comparative safety of dollar assets.
"One of the most disappointing things for EM investors is that the dollar is not selling off," Baweja says.
The result is that emerging markets face tighter conditions in a world of slower growth, as the dollar's relative strength makes borrowing more expensive. This makes it harder for companies and governments to invest — and exposes the fact that many countries failed to get their economies into better shape during the boom years.
According to the IIF, total corporate debt in emerging markets (excluding the financial sector) was equal to 93 per cent of GDP at the end of March, up from 60 per cent two decades earlier.
In developed markets corporate debt was equal to 91 per cent of GDP in March. But the money does not seem to have been well spent, despite widespread improvements in monetary and fiscal discipline among someemerging market governments.
"A lot of EM economies have become more like developed markets, in that they have a lot of non-financial corporate debt and low inflation," says Murat Ulgen, global head of EM research at HSBC. "But a lot of the gains from cutting inflation and achieving monetary stability have been reaped, so those debts are now a drag on growth."
He notes that in many countries, credit growth among companies and households has outstripped nominal GDP growth over the past decade, at the same time as productivity has declined. Borrowed money has been spent on services or consumption, or on paying down previous debts, rather than on productive investment.
Ulgen says that, in the long term, many emerging markets should be able to take advantage of factors such as demographic trends, urbanisation and technology to regain their edge for investors over developed economies.
But to do so, they will need to resume the reform efforts that many put to one side during the years of prosperity.
Will they do so? Brooks at the IIF is not optimistic. "There is no magic bullet," he says.
"The only thing you can do is work on the transparency of institutions and on other structural reforms, which are so painful that nobody wants to do them."
He questions the idea that emerging markets will converge over time with the developed world. China's entry to the WTO, he says, was a transformational moment for emerging markets, but also a one-off event, whose benefits are being undermined and in some cases reversed by the rise of populism and nationalism.
"Is there any reason to expect the idea of convergence to play out?" he asks. "I think it's very murky. The pessimistic view, which is the one I have, is that the past 20 to 30 years were an exception."
Written by: Jonathan Wheatley
© Financial Times