Emerging Markets Weekly

There has been a lot of water under the bridge since Goldman Sachs released its initial report in 2003 detailing the growth potential of BRIC nations by 2050. Seven years later, the analysis looks prescient albeit too conservative. BRIC nations grew faster than expected and accounted for a greater share of the global growth than anyone might have imagined. Part of the reason for the superior growth performance of the BRIC nations versus the G7 countries is accounted for by the abject weakness of the latter countries since 2007. Yet the fact that the BRIC nations maintained strong annual growth rates despite the crisis is testament to their better economic fundamentals relative to the United States, Japan and Germany for example.

BRIC countries have therefore received a serious upgrade on an absolute and relative basis in the most recent report from Goldman Sachs that updates their economic projections for 2050. China, India, Brazil and Russia are now projected to occupy four out of the top five spots in terms of size measured by GDP in US$ at market exchange rates. The outlook for China is greatly improved in terms of absolute GDP which is perhaps not surprising given that in light of recent strength in China and expectations for China to move ahead of Japan this year to become the second biggest economy in the world.

The end point of convergence is admittedly 40 years off and there will be setbacks along the way to be sure. However, it is hard to argue with the logic that there are far greater opportunities for long term investors in the emerging markets over the long term.

Emerging Markets Weekly

The global trade rebound over the past year has been largely unreported but represents an important development for export oriented countries such as China. What has been widely reported is the export-led economic slowdown in China in the fourth quarter of 2008 due to the global credit crisis, capital flight from China and the sharp fall in global trade. In response to the abrupt slowdown in China’s economy, policymakers enacted a US$586-billion fiscal stimulus in conjunction with a very aggressive monetary stimulus through the banking system. What is notable about the sharp growth rebound is that it was dominated by fixed asset investment although retail sales did expand strongly over the past year from a low base.

What is encouraging now, is the fact that exports have rebounded strongly since March 2009 which represents the nadir for the global credit crisis. Exports basically fell off the map as the chart below illustrates. After peaking at roughly US$140-billion in October 2008, they were cut by more than half up until they bottomed at close to US$60-billion in March 2009. Notice the impressive rebound in exports over the balance of the year where they finished just shy of the high water mark in 2008.

The rebound in exports is important because China has been heavily reliant on government stimulus over the past year and needs to move to a more balanced form of economic growth. While it will take several years to rebalance the economy toward domestic demand, the rebound in trade is a very important development from a near term perspective.

Emerging Markets Weekly

Russia appears to be significantly less advanced than the other three BRIC countries in terms of inflationary pressures and therefore in its need for tighter monetary policy. Inflation is actually falling in Russia unlike the experience for Brazil, India and China where inflation has been rising on a monthly and annual basis since the end of 2009. That goes part way to explaining why equity prices in Russia bucked the recent sell off and actually appreciated over the past month in the face of a global equity market correction.

Russia’s economy has been slower to respond to the global economic recovery with manufacturing activity only recently turning positive; the purchasing manager index signaling expansion (50.8) in January after contraction in the final quarter of 2009.

Whereas inflation was high and rising in January 2009, hitting over 13% due to a depreciating ruble, that issue proved fleeting, and inflation has subsided over the past year. Inflation fell to 8.8% in December 2009 taking pressure off the central bank to tighten policy.

In fact rates continue to come down and are currently sitting at 8.75% after a series of interest rates cuts in response to the weaker economic environment.

The other encouraging front in Russia is equity valuations. The market trades at roughly a PE ratio of 8.4 and price to book ratio of 1.1 based on a US$70 oil price according to research by Troika Dialogue suggesting that Russian equities remain cheap even after a doubling in share prices in 2009. Lets not forget that valuations were at bombed out levels back in March of 2009 trading on a historical PE basis of less than 4 according to data from MSCI Barra.

Emerging Markets Weekly

The message was right but the timing was all wrong when the IMF released an update to its World Economic Outlook last week, announcing that “risk appetite has returned” just as global financial markets were choking on the olive pit of Greek government finances.

Market sentiment shifted over the past week from hope to worry with particular focus on policy tightening in China and the prospects of sovereign default in Greece. The latter issue looks real and intractable with Greece getting knocked out of the European Monetary Union a distinct possibility within the next two years. Policy tightening in China to curb runaway loan growth is a buying opportunity however.

Investors are fretting that as Beijing reins in its bankers from handing out loans as freely as advice that China’s economy will come crashing down. Speaking of advice, Confucius said that, “He who will not economize will have to agonize,” and a little prudence in lending is no bad thing.

Investors are missing the fact that Beijing is simply taking its foot off the accelerator rather than hammering on the brakes. They are still planning to extend nearly twice as many loans in 2010 (in value) as in 2008. And turning back to the IMF update, the global economy is expected to grow 3.9% in 2010 and 4.3% in 2011, a two speed recovery to be sure with emerging economies in the fast lane growing 6% this year and 6.3% in 2011 according to IMF estimates. The advanced economies will see growth of only 2.1% this year and 2.4% in 2011. China is expected to grow 10% in 2010 and 9.7% in 2011.

The MSCI China Index and the Hang Seng Index in Hong Kong have corrected 10% since January 11th setting up a buying opportunity for the next leg of the bull market.