Last week marked the 10th anniversary of the Thai baht devaluation, the event in hindsight that saw the beginning of the Asian crisis. Given the severity of the crisis and how deeply it affected most Asian economies, one saw numerous research reports marking this anniversary and providing perspective on what actually happened. It is also amazing to see and reflect on just how strongly the whole emerging market asset class has come back into fashion from the dark days of the end of 1997-98.
At the bottom of the Asian crisis, the whole EM asset class was called into question, and there were many people even calling for the death of the asset class. At the bottom, even on a 10-year basis investors had only lost money (in dollars) in most emerging markets, and at a time when the US and European markets were forming new highs.
Given all the economic issues these markets faced in the 1990s, the volatility of returns in the emerging markets was also much higher than in the US and Europe. Savvy investors were justified in asking as to why they should invest in an asset class that had higher volatility and delivered to them lower returns than simply buying the S&P 500.
Why should they take the risk and make the effort of buying companies in far-flung geographies (with the corporate governance headache), yet still get lower returns than buying GE?
Of course all that was then and such talk marked the bottom of sentiment towards emerging markets. Over the last few years, the emerging markets asset class has come roaring back.
At its bottom in August-September 1998, the whole EM universe traded below book value and at a 70 per cent discount to the price/book multiple of the MSCI World index. The return on equity for the entire EM universe went below 5 per cent and even on such low profitability, PE multiples were at a discount to the MSCI World index.
Since the beginning of 1999, the MSCI EM index has outperformed the MSCI World index by a compound 12 per cent per annum in dollar terms (source: Morgan Stanley) and we have seen convergence in all valuation multiples (price earnings, price/book multiples and dividend yields are all either at or very close to parity between the MSCI EM and MSCI World).
Forget a discount which had been the norm, many of the EM bulls are now making a case as to why the EM universe should trade at a premium, given its higher growth rates and higher RoEs.
Given the sustained out-performance, we have seen more and more institutions and individuals raise their weightings towards the emerging markets with many taking a secular long-term view of where the future engines of economic growth reside.
This process of reallocation of capital from the US and Europe towards Asia, Latin America and the BRIC countries is still ongoing. To the extent this is a secular shift in capital allocation, you have a natural bid towards the EM asset class as most institutions are nowhere near their long-term desired weightings, and the quantum of capital, which can shift is large enough to impact the asset class.
Having had such a huge run, many market observers are now beginning to get nervous on the EM asset class. Obviously emerging markets cannot continue to outperform the developed markets indefinitely. Since the valuation gap between the emerging markets and developed markets has closed, for the EM asset class to continue to outperform either valuations will have to go to a premium or the EM universe has to sustain higher earnings growth.
The other longer-term secular driver of returns is the continued likelihood of currency appreciation for most of the larger emerging markets. The bulls make the case as to how earnings in the EM universe will continue to outpace their more developed brethren, and lay out the economic rationale for this in terms of demographics, outsourcing, domestic consumption, etc.
Be that as it may, the fact is that it will be much harder from here on for the EM universe to sustain continued relative out-performance vis-a-vis the MSCI World Index. Even if out-performance does sustain it cannot be at double-digit levels.
Given the above backdrop for the EM universe we should not get carried away in India. The country has had a huge run since 2003, and been one of the better-performing markets in the EM universe, but this has also been an extraordinary time for the whole asset class. If sentiment towards the asset class weakens, India will go down irrespective of what is happening on the ground.
It is true that India has now been truly discovered, and, being a trillion-dollar economy and with greater than a trillion-dollar market cap (just crossed Korea), it can no longer be ignored. However, having become part of the EM mainstream, we are much more hostage to global EM sentiment and flows than the case historically.
The issue for investors in India is whether at 8-9 per cent GDP growth, the country can experience its own version of the goldilocks scenario. Has our growth potential expanded enough so that 8 per cent GDP growth is slow enough to not cause overheating and a surge in inflation, but still fast enough to sustain strong near 20 per cent corporate earnings growth?
Can we improve our productivity performance so that even at 8 per cent growth, inflation behaves and the RBI is not compelled to intervene and spoil the party? If we can sustain this growth dynamic, then it is incredibly powerful and one can then argue for sustained high earnings growth and therefore PE multiples.
This dynamic can trigger and sustain a virtuous circle like what we have experienced over the last 3-4 years. Strong economic growth leads to strong earnings, which lead to strong markets, and strong markets allow companies to access capital to invest and sustain the economic and profits growth.
India now has the burden of expectations. Investors and, for that matter, voters will no longer accept even 7 per cent growth. We need to deliver strong 8 per cent plus GDP growth and near 20 per cent earnings to justify and fulfil expectations.
Are we, as a country, doing enough to improve our long-term growth potential through sustained productivity improvements? The corporate sector in India is clearly doing its part; it is the government that worries me.
We still have far too many rigidities in the system that remain un-addressed. These have to be addressed and the so-called second generation of reforms have to be more than an esoteric concept or buzzword.