Emerging Markets Beyond China: Reforms and Opportunities in India and Brazil
Six weeks ago in these pages, we wrote that 2019 might be the year during which emerging markets finally begin to outperform. We argued that after a decade of emerging-market underpeformance, global investment flows would begin favoring EM assets again — if the economic and financial backdrop were solid and some potential problems were resolved.
Fast forward to today. The potential problems have not been resolved, and the economic backdrop continues to cause investors some anxiety about global growth. Emerging markets, although they participated in the rally that followed December’s stock-market selloff, have largely moved sideways. (Brazil did not suffer as much of a decline in the last quarter of 2018, but also did not experience as much of a rally afterwards.) In the last six months, China, Brazil, and Indian stocks have performed about in line with the U.S.
Source: Bloomberg, LLP
What are those potential problems?
First and foremost is trade. The back-and-forth in negotiations between the U.S. and China is continuing, casting a pall on investors’ appetite for emerging markets. As we’ve noted, China is much more economically vulnerable to U.S. trade actions than the U.S. is to Chinese. The domestic Chinese stock market is driven primarily by the sentiment of local investors, and it is unclear what will win the battle for those investors’ psychology. Will it be national pride and a conviction that the central government’s stimulus efforts will accelerate still further? Or will it be fear that the economic consequences will become more dire?
Beyond China, a similar tug-of-war is in effect. On the one hand, the longer the conflict continues, the more global supply chains will adapt, shift, and benefit manufacturers and exporters outside the People’s Republic. On the other hand, the more economic pain the People’s Republic endures, the more its neighbors will experience a slowdown in Chinese demand.
And beyond the Asian markets in China’s immediate orbit, there remains a nebulous anxiety that the conflict between the U.S. and China will chill global trade generally… and that this will spell trouble for most emerging-market economies, which are fundamentally export-driven. This anxiety is not entirely rational, because emerging markets beyond China have their own characteristics, and many global investors remain hungry for the growth that emerging markets represent.
The second worry is economic growth. The consensus of many globally influential analysts at organizations such as the International Monetary Fund [IMF] is that global growth is decelerating. In October, 2018, the IMF projected 3.7% growth for the world economy in 2019; by January that was down to 3.5%, and last month, it was reduced to 3.2%. We are not endorsing the IMF’s view. However, it is an influential one, and many global investors will hesitate to expand their ownership of emerging-market assets in a perceived environment of growth deceleration. The IMF puts a lot of the responsibility for soft growth on trade conflict.
Source: IMF
The third worry was central bank policy — but that’s been put to rest. We’ve written several times recently about the supportive role being played by global central banks. After some policy and communication missteps that helped precipitate the fourth-quarter correction, the U.S. Federal Reserve has corrected course. It may need to do more to keep market participants happy; currently the market is pricing in expectations for a Fed rate cut which may or may not materialize. As always we will watch Fed behavior closely. We wrote last week that inflation is likely to continue being low for some deep, structural reasons — mostly connected with technology. This will allow central banks to maintain looser monetary policies for longer, and that will support markets. Beyond the U.S., many global central banks in both developed and emerging-market economies are in easing mode.
Beyond China
Even though the U.S./China trade conflict has dominated investors’ attention, though, we think there is potential elsewhere in the developing world. When the trade conflict runs its course — an outcome we continue to believe both the U.S. and China are powerfully incentivized to achieve — attention will turn to other growth stories in emerging markets. There are events unfolding outside the media limelight of U.S./China drama that will set the stage for investor enthusiasm once trade and growth fears are calmed.
India
India is one of the world’s real potential growth superstars, with an economy growing at +8% according to official government statistics, strong domestic consumption, strong services exports, and the potential to seize some of the manufacturing that is leaving China due to trade-related supply chain diversification and Chinese wage growth. India was hobbled for a long time in its growth possibilities by dysfunctional domestic financial and economic policy. When Narendra Modi became Prime Minister in 2014, markets were enthusiastic that he might shift policy in a more growth-friendly direction. He has made significant reform gains, and has more to accomplish.
As we write, India has just announced the results of elections to its lower parliamentary house, the Lok Sabha. Modi’s party and its allies gained a strong mandate which he may be able to use to help push through further and deeper reforms.
What are the items markets would like to see in an accelerated Indian reform agenda?
Reforms making it easier for businesses to acquire land — including the digitization of land records. These records are so cumbersome that businesses are often prevented from acquiring the land they need to build and expand, or they face interminable court proceedings.
Reforms easing labor laws, simplifying regulations and reducing onerous burdens faced by larger firms (something which has made it hard for manufacturers to expand and compete in the global marketplace).
Privatization, especially in banking, where state-owned banks are dominant and inefficient.
And derived from all the above, the active promotion of manufacturing export growth.
If the ruling coalition in India is able to accelerate these critical reforms, economic growth could reach 9-10% annually — which certainly create enthusiasm for Indian equities among global investors.
Brazil
Brazil is earlier along its reform path than India. While India’s business-friendly Prime Minister was elected in 2014, Brazil’s reform-minded President, Jair Bolsonaro, was elected last October in a protest-vote landslide and has been in office since January. Readers will remember that he was elected following the ignominious downfall of Brazil’s ruling Workers’ Party after a long corruption scandal — a period that coincided with a prolonged and very painful recession. The boom years of growth that had been fueled largely by commodity exports to China had receded, and left little to show except looming fiscal disaster from unsustainable entitlement spending. Brazil has a developing-world economy, and developed-world social spending — a recipe for future fiscal disaster.
Markets were initially very enthusiastic about prospects for reform — as they had been in India with Modi’s election in 2014. That enthusiasm quickly moderated as the difficulty of getting reforms through became more clear. Brazil’s stock market is still some 20% higher than it was when Bolsonaro was elected, but has spent much of 2019 treading water, as hopes for a rapid capitalization on his electoral landslide dissipated and struggles over pension reform lumbered on.
Recent political developments have some analysts cautiously hopeful that a pension reform bill can make it through Brazil’s congress in the near future, despite turmoil surrounding Bolsonaroa’s administration. (Like President Trump, he is a politician who seems to court controversy, and often to revel in it.) If that happens, there will likely be a relief rally, particularly if it coincides with a shift in global investor sentiment sparked by good news on the U.S./China trade front.
Success in pension reform could open the door to tax reform, which would further bolster investor sentiment towards Brazil’s longer-term prospects. Pension reform failure, however, would be a severe blow and likely cause a retrenchment in Brazilian stocks — perhaps giving up much of the rally that followed Bolsonaroa’s election. We note that Bolsonaro has yet not proved himself as a leader who can effectively build consensus in the same way that Modi has in India.
Investment implications: In both India and Brazil, continued stock market performance will hinge on their governments delivering further progress in significant reforms. If that progress comes — business-friendly regulatory changes and privatization moves in India, and pension, fiscal, and tax reforms in Brazil — economic growth will accelerate, and in anticipation, stocks may re-rate based on those expectations. India’s recent parliamentary elections delivered a strong mandate for deepened reforms and will strengthen the government’s hand.
