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Emerging Markets: Some Good News at Last?

Government reforms, improving productivity and a renewed flair for innovation will be key factors for these economies in the months and years ahead

AFTER ABOUT A DECADE of strong performance, the last five years have been unkind to Emerging Markets (EMs) as the tailwinds that propelled them have faded (see box). A slowdown in growth in China pulled down demand for hard commodities such as copper, steel and iron ore. This development, along with a precipitous decline in oil prices, has been brutal for commodity-exporting nations such as Brazil, Russia and Venezuela. Sentiment also soured due to a relentless rise in the U.S. dollar, lack of credible reforms and economic mismanagement.

However, investors' appetite for EMs has improved this year on the back of a more stable U.S. dollar, recovering commodity prices and diminished concern over the pace of economic growth in China. Valuations, particularly relative to developed markets, are one of the main attractions (see Exhibit 1). As such we have upgraded our view on EM equities, but we recommend being very selective. As long-term investors we see the opportunities of the future in countries with strong commitments to economic, financial and structural reforms and sectors providing exposure to consumer spending, especially in China, India and Brazil.

What drove Emerging Market (EM) growth during the golden years?

In 2003, EM assets were at attractive valuations relative to developed markets, as most of these countries were coming out of periods of crisis. Coupled with that was a favorable macroeconomic backdrop that included the following factors, which often interacted and functioned in combination with one another:

  1. A secular decline in U.S. and global real interest rates
  2. An environment of relatively benign inflation
  3. Globalization, which helped several of these countries integrate into the global economy and trade; China is a poster child for this trend
  4. A steady rise in commodity prices, fueled by a combination of strong global demand, especially from EMs, and a relatively muted U.S. dollar exchange rate during most of the period
  5. Improvement of external balance sheets that included pay-down or other resolution of debts in most countries as they were leaving the crises of the 1990s behind them


If EMs are going to continue growing at higher rates, and regain the competitiveness they enjoyed against developed markets for several decades, more of the gains need to come from improvements in productivity, and innovation must play a bigger role.

Another area that could lead to improvement, in part through enhancing productivity, is reforms. Each country is unique in the areas that need them, and faces its own idiosyncratic issues and opportunities.

A third likely driver of faster growth is the rise of the middle class. With increases in incomes and living standards, bringing more and more people out of poverty, a significant middle class is taking shape in EMs, which will have its own needs, and will shift the focus from saving and investments to consumption.

Need for innovation

Despite significant progress, when it comes to productivity emerging economies are still lagging developed ones, where it is still almost five times higher.1

Emerging Market companies have a strong growth orientation, and some argue that their ownership structure is a favorable factor for promoting productivity-led competitiveness.2 Many large EM firms are privately held, including many that are family-controlled, which enables them to undertake longer-term projects with meaningful impacts on productivity and innovation, accepting lower rates of return in the short run with the expectation that the gains in future market share will more than make up for it.

Among EMs, China is well-positioned for strong increases in productivity through innovation. The country has been transforming from an importer of innovations to a leading producer of them. Innovation metrics such as R&D spending and the number of patent applications have been increasing rapidly for the last two decades, surpassing those of more developed economies (see Exhibit 2).


The McKinsey Global Institute argues that China is ripe for a productivity revolution, and estimates that if the country successfully shifts to a productivity-led growth model it could add $5.6 trillion to its gross domestic product (GDP) by 2030.3

Our base case is that China can grow at a sustainable 6% rate over the next few years. The government is promoting balanced growth through the recently released five-year plan, which aims to improve productivity through approaches such as automation of factories and investments in higher-end knowledge and skills.

Potential from reforms

Among EMs, China has perhaps the strongest track record of reforms, going back to the 1980s when it began transforming from a centrally-planned economy to a market-oriented one. The Third Plenum of 2013 set out a reform agenda with a time horizon of five to 10 years that addressed environmental policy, sustainable urban development, transitioning toward less state control of the economy, a better fiscal framework and financial liberalization, as well as anti-corruption measures.

Brazil is a well-functioning democracy, but among the reforms that it needs are short-term improvements to address fiscal revenues and spending, as well as longer-term structural changes aimed at more open markets, global integration and greater investment in both physical infrastructure and human capital. The country needs to reduce the government's share of economic activity, which at about 40% of GDP is very high among Emerging Markets, and crowds out investments by the private sector. It must also diversify away its outsize reliance on commodities, which makes it vulnerable to downturns in demand and prices, as the one that has been unfolding since the middle of 2014 has demonstrated.

India is another reform-minded country, especially since Narendra Modi's administration came to power in 2014, and set out to streamline the huge and largely ineffective government bureaucracy from the federal level down to state and local governments. It has also been working to encourage foreign investment in manufacturing and infrastructure, and to reform fiscal policy, labor markets and the energy sector. The latter had been plagued by an inadequate legal and regulatory framework, making it prone to breakdowns and leading to inefficiencies. For example, 18% of power output is lost during transmission and distribution, compared to 6% in China and the U.S.4 The world's largest power failure occurred in India in 2012, a blackout that left 620 million people without electricity. Reform could also yield large benefits where it can improve the transportation and distribution of agricultural produce; according to the World Economic Forum, a whopping 70% of the fruit and vegetables produced in India is wasted.

In Mexico, corruption and crime remain, but there has been relative stability in the country's political institutions. The environment is making it easier to enact structural reforms, such as those recently passed for the energy sector, which should support private investment.

Saudi Arabia is another case worth noting. With a resource-driven economy dependent on petroleum revenue for decades, it recently launched an ambitious program called Vision 2030 to diversify its economy.5 The program includes reduction of public subsidies, fiscal reform, a more internationally open society and, remarkably, the public listing of Saudi Aramco, the world's largest oil company.

The burgeoning middle class

With the rise in incomes and living standards, and more and more people coming out of poverty, a significant middle class is taking shape in EMs, leading countries to shift their focus from saving and investment toward consumption.

A lot has been written about the Chinese consumer, and the country's shift away from investment toward consumption. Investment will continue to expand, but at a more gradual pace. The consumer's share of GDP is projected to rise to about 40% in 2017. This reflects progress, but to put it in perspective, consumption represents about 60% of GDP in Emerging Markets, and 70% in the U.S., implying that China still has a lot of distance to cover. In contrast, investment in China is expected to fall to 41% of GDP next year from 44% in 2015 and 47% in 2011. Consumer confidence in China has remained resilient over the past few years despite the economic slowdown and stock market volatility. Chinese household debt is still relatively low, which could result in robust consumer purchasing power. Consumer spending is shifting from products to services, in-store to online, and low-end to middle- and high-end.


In the broader EM world, literally billions of people coming out of extreme poverty are expected to form a gigantic consumer market. BofA Merrill Lynch (BofAML) Global Research has examined this trend, and concluded that the 4.5 billion people who now earn less than $10 per day have $5 trillion in purchasing power and $7.4 trillion in wealth. They are young, urban, digitally connected and well-educated. More than three billion of them are projected to be in the middle class by 2030, which could represent the largest boost to the global economy since the boom following the Second World War.6

Another country with a strong consumer base is Mexico. Its robust spending has been fueled to a large degree by remittances from workers in other countries. Over the coming years, we believe the country should see growth in jobs and consumption as a result of rising wages in China, making it a more attractive alternative for production. Greater use of banks and other financial services on the part of the population should expand the availability of credit, adding further to growth.

Portfolio Considerations: EM equities remain attractive for long-term investors and, as such, those who eschewed them in the last few years should consider reintroducing them in portfolios. The weights depend on the individual's risk profile and time horizon. Investors with aggressive risk profiles and longer-time horizons could opt for higher allocations. For conservative investors, we recommend considering developed market companies with exposure to EM economies. Opportunities in the long term will likely be in areas that benefit from consumer spending, while near-term ones should be in beaten-down cyclical areas. We advise being selective and prefer active managers over passive investments. India and China have made some meaningful reforms recently and are positioned for 6% –7% annual GDP growth. India, while playing catch-up to China's blazing economic progress over the past 25 years, should also be the beneficiary of a growing and younger labor force. Brazil is undergoing a political and economic reboot and, as such, is not for the faint of heart. Investors will need more patience, a long-term approach and greater tolerance for volatility.

3 Questions to Ask Your Advisor

  1. How could I invest in reform-minded economies like China, India and Mexico?
  2. What investment opportunities might arise from the world's rapidly growing middle class?
  3. What sort of allocation to emerging market equities is appropriate for me?

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1 McKinsey Global Institute, “Global growth: can productivity save the day in an aging world?” January 2015.

2 See McKinsey Global Institute. “Playing to win: the new global competition for corporate profits,” September 2015. Also, the two McKinsey Quarterly articles:
“The family-business factor in emerging markets,” December 2014, and “Parsing the growth advantage of emerging market companies,” May 2012.

3 McKinsey Global Institute, “China’s choice: capturing the $5 trillion productivity opportunity,” June 2016.

4 World Bank. World Development Indicators, 2016 (data as of 2013 for all countries, accessed on June 20, 2016).

5 Johnson, K., “Saudi Arabia Plans to Break Its ‘Addiction’ to Oil,” Foreign Policy, April 25, 2016. Also El-Katiri, L., “Saudi Arabia’s New Economic Reforms: A Concise Explainer,”
Harvard Business Review, May 17, 2016.

6 BofAML Global Research, “Thematic Investing: Moving on Up — Bottom Billions Primer,” February 25, 2016.

Investing in Emerging Markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.


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