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This week, the continuing strength of global equities in the face of several shocks to the world economy became more impressive, or more puzzling, depending on your point of view. Oil prices rose to a level which will be a serious problem for the uspwing, should it persist. (See this earlier blog.) The ECB became the first of the major central banks to tighten monetary policy. Portugal finally accepted the inevitable. And yet global equities continued to rise.
Furthermore, emerging markets significantly outperformed their developed market counterparts, reversing part of their under-performance in the first few weeks of the year. Several investment banks have now tipped the emerging markets as the right place to be if the developed economies slow under the weight of rising oil prices later in the year. But I am far from convinced about this.
Many equity managers have made their careers on the emerging market “bet” in the past decade. With emerging economies growing at twice the rate of the developed world, what (in retrospect) could have been more obvious? And GDP growth in many emerging countries, especially in Asia, looks set to remain robust for an indefinite period ahead, so it seems inevitable to many investors that the out-performance of the equity markets will swiftly resume. That, however, is far from inevitable.
It is now well established that, over very long periods of time, real GDP growth is not correlated at all with the relative performance of equity markets. (See for example this classic piece by Jay Ritter.) Economic growth often requires the application of additional capital, which involves expanding the number of shares in issue, in which case the benefit of GDP growth does not go to the original shareholders. Or GDP growth stems from technological advances, where the benefits often accrue to the economy at large, rather than to stockholders. Of course, there are exceptions, as any shareholder in Apple could testify. But over long periods, these rules tend to apply.
Admittedly they did not appear to apply in the last decade. Emerging economies enjoyed the fastest GDP growth, and also the best equity performance, in the world. But the connection may have been illusory. Much of the strong performance of emerging markets may not have occurred just because growth was strong, but because growth was surprisingly strong. There is no doubt that when GDP rises unexpectedly, compared to what had been previously discounted in the markets, then equities will rise.
The upward breakpoint for GDP growth in the emerging world, compared to the developed world, happened in the late 1990s, and it was at first met with scepticism by many economists. Only when it persisted throughout the last decade did markets fully adjust to the dramatic change which had taken place. However, the strength of growth in countries like China and India has now become the conventional wisdom. There is surely little scope for a further favourable surprise from here.
The growth surprise was not the only factor at work in the 2000s. As the graph shows, emerging equity markets entered the last decade with very attractive valuations compared to the developed markets. There is no debate about the fact that starting valuations, unlike trends in GDP growth, do succeed in signalling good or bad equity performance over long periods ahead. Relative valuation definitely underpinned the rise in emerging markets after 2000. Markets had been undervalued by investors who had just experienced the Asian and Russian shocks in 1997/98. Risk premia were exceptionally high, in fact much higher than were justified by the internal and external debt ratios of the economies concerned. As this became clear, markets rose.
The relative valuation of emerging equities is no longer particularly attractive, either relative to their own history, or relative to developed equities. Certainly, emerging market valuation has not reached the extremes which were seen in 2007 and 2009, which means that periods of out-performance from here are perfectly possible. But the valuation underpinning which existed until about 2006 has certainly now disappeared.
These arguments seem to suggest that the large, trend rise in emerging markets may have already ended. Like other investments, they will out-perform in some periods, and under-perform in others, according to the prevailing economic conditions at the time. In fact, this is what has actually been happening since 2008. Investors can no longer simply sit back and enjoy the ride, confident that superior GDP growth will inevitably result in superior market performance. We will have to work for our living.
On that, more another time. But in brief it seems to me that developed economies are still in a more favourable place in their economic cycle than several large emerging countries. There is clearly still a large output gap in the developed world, while in the emerging world there is not. Inflation pressures are now beginning to appear almost everywhere, but the emerging central banks are clearly more motivated to tighten policy than either Europe or (especially) the US. And emerging currencies are now rising fairly consistently against the dollar, which may eventually cause problems for corporate profits. All this raises doubts in my mind about whether the emerging markets will enjoy a vintage year.
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Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.
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