Does economic growth equal equity returns?
Jan Dehn, Ashmore
Perhaps the most common long-term reason given by emerging market bulls for investing in the sector is levels of economic growth which leave developed market growth looking anaemic. Is this a watertight argument?
Sceptics often cite research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, produced in association with Credit Suisse. It finds that between 1900 and 2013, there was a negative correlation between real-terms equity returns and per capita GDP growth.
Advocates of emerging markets say this stark fact does not, however, negate the argument for gravitating to high-growth economies.
The LBS research only looked at large-caps, which are often subject to government interference that destroys shareholder value, says Jan Dehn, London-based head of research at Ashmore, the emerging markets specialist.
He cites the example of Petrobras, the Brazilian energy company. “When the government instructs Petrobras not to raise fuel prices at the pumps, then it has to follow this. That means margins get squeezed when oil prices go up, and it can’t pay dividends.”
Mr Dehn concludes: “These state-controlled companies are not representative of the private-sector business environment in emerging markets,” which is the sector groups such as Ashmore concentrate on.
Government control explains the anomaly of poor Chinese stock market returns despite breakneck economic growth for many years, says Allan Conway, head of emerging market equities at Schroders in London. About 90 percent of the stock market, by market cap, is in the hands of state-owned enterprises. Where private enterprise is allowed to flourish, returns in a high-growth economy can be very high, says Mr Conway - citing Japan in the 1960s and 1970s as the classic case.
If this distinction is correct, private bankers need to concentrate their investments in emerging markets relatively free from government control.
The very different ratios between economic growth and corporate earnings growth in developed and emerging markets are contrasted by Cesar Perez, chief investment strategist for Europe, the Middle East and Africa at JP Morgan Private Bank in London. The bank forecasts economic growth this year of 2 to 2.5 per cent in Europe, with earnings growth of 7 to 9 per cent - a 3 to 1 ratio. In emerging markets, by contrast, the ratio is mere 1 to 1 - with output growth of 5 or 6 per cent matched by a similar figure for earnings growth. His solution is to concentrate on countries such as India where companies show interest in shareholder value, including dividend payments. “You have to look at whether a company is run for you or not,” says Mr Perez.
