The following is excerpted from a Q&A between James Tracy, National Sales Director for Morgan Stanley Smith Barney, and Ruchir Sharma, head of emerging markets equities at Morgan Stanley Investment Management, and author of the book, Breakout Nations: In Pursuit of the Next Economic Miracles. The Q&A is featured in the August issue of “On the Markets,” from the Morgan Stanley Smith Barney Global Investment Committee, which can be found here.
James Tracy (JT): Morgan Stanley Smith Barney's Global Investment Committee has long been a proponent of investing in the emerging markets. As you point out in
Breakout Nations, not all emerging markets are alike. Let's start with the BRICs—Brazil, Russia, India and China. What's going on in those countries?
Ruchir Sharma (RS): To address your first point, MSIM's asset allocation work shows that the long-term expected returns from the emerging markets will remain relatively high as compared with other asset classes. However, there are some major shifts taking place [away from] what happened over the previous decade. Over the previous decade, a tide of global liquidity lifted nearly every market.
Now, a leadership shift is under way as some of the BRICs are slowing at a pace that's taking investors by surprise, and other emerging markets are coming to the fore. Take the case of Brazil. Its economic growth rate this year is not likely to be much above 2%. For that economy not to be growing more quickly than the US is a real disappointment, given the risks.
The same is true for Russia. While its slowdown has not been as pronounced as Brazil's, Russia's growth rate has fallen significantly from the highs of the previous decade. It'll be lucky to get to 4% growth, even though oil prices have remained relatively high.
Then there's China. China is really a victim of its own success: After having grown at 10% for three decades, it is at a level where growth rates tend to naturally slow down. The days of double-digit growth are behind it. India could easily replace it as the fastest-growing economy in the world.
JT: What do you like about India's economy?
RS: I like its diversity. The problem with Russia is that it is so dependent on commodity prices. If commodities — oil, in particular — don't do well, there is very little else going on in the economy. Even Russia's service sector of the economy is highly dependent on oil. India has a much more diverse economy, and that diversity runs deep. India is similar to the US in that regard, with many states and lots of different actors on the stage. So you get a lot of breadth. What is disappointing is that, with per capita income so low, India ideally should be the fastest-growing economy in the world and not lag behind China. India, however, has spent much of the past few years redistributing rather than growing the economic pie. That has allowed government spending to get out of control and is leading to high interest rates and inflation.
JT: The infrastructure of Brazil is often cited as one of the things holding back its growth. What's your view on Brazil?
RS: I travel to all these emerging markets and what strikes me about Brazil is that it is possibly the only major emerging market that didn't capitalize on the boom of the past decade to build a new airport. That, to me, is just symptomatic of the issues in Brazil.
Brazil has come a long way from the '80s and '90s, when its economy was unstable and suffered from hyperinflation. However, its 2% growth rate is disappointing. The reason for that is that its infrastructure is abysmal. Spending on infrastructure is among the lowest of any developing country: The average emerging market nation spends about 5% of its economy on infrastructure. At one end of the spectrum is China, which spends 10%; at the other is Brazil, which [spends] only 2%.
JT: Clearly, China's economy is slowing. What effect will that have on the global economy?
RS: China's slowdown has major implications for commodities, in particular. Commodities and commodity stocks did very well over the past decade, rising at a breakneck pace because of explosive demand from China.
At the same time, commodity supply was constrained. Over the past few years, the commodities sector is the only one that added capacity. At the same time, China's economy is maturing. China accounts for 30% to 60% of the demand for most industrial commodities. China accounts for 10% of total demand for oil and, over the past decade, it has accounted for 50% of the incremental [increase in] demand. As China's growth slows and new sources of supply come on stream, commodity prices could be weak for the coming decade. That has major implications for commodity-exporting countries such as Australia and Canada and for emerging markets such as Brazil and Russia. On the other hand, this could have major, positive implications for many commodity-importing countries, including the US. As the price of oil and other commodities declines, the US could be a beneficiary. Similarly, among the emerging markets, there are countries like India and Turkey that import a huge amount of commodities. A reduction in the price of oil and other commodities will [work as] a tax cut for those economies. This is one of the themes of my book: that emerging market leadership is shifting away from the winners of the past decade, particularly the commodity-exporting countries and sectors, and possibly toward the commodity-importing countries.
JT: Can you define what you mean by the term “breakout nation”?
RS: There are two criteria I use to define a breakout nation. One is the notion of expectations. The key thing about breakout nations is that they exceed expectations. The role of expectations is something that people underestimate. People ask me: “What's the big deal if India is growing at only 5.5% to 6.0% now, compared with the 8.0% to 9.0% growth rate?” Well, the problem is if you're expecting 8.0% to 9.0% and you get 5.5% to 6.0%, it feels like a recession.
The second thing [I do] is adjust for per capita income, [a factor] many people don't fully appreciate. When an country like India or Nigeria (which has a per capita income of $1,500 annually) grows at 4.0% to 5.0%, that's a pretty underwhelming achievement. But when South Korea, with a per capita income of $20,000, is able to grow at 3.5% to 4.0%, or [when] the US, with a per capita income of $45,000, is able to grow at 3.0%, that's a big achievement.
The point about breakout nations is to identify countries where expectations are relatively reasonable and are being met, and to [take] per capita income into account when making those assumptions. On that basis, many countries in Southeast Asia, such as the Philippines, Thailand and Indonesia, fit the criteria. Poland and Turkey could, too. Even an economy like South Korea appears to be in decent [enough] shape to be a breakout nation.
JT: Can some of these breakout nations become the engines of global growth?
RS: I don't think breakout nations can support growth the way [emerging markets] did last decade. Last decade, the average growth in the emerging markets was 6.0%, and during the peak periods of 2003 to 2008, the growth rate was more like 7.5%. I don't think those growth rates are coming back. They were artificially high because of the easy money conditions across the globe. I think that the breakout nations [potentially] can grow at about 4.5% on average, which is not bad but is not the same as the past decade.
JT: How do you implement this shift to breakout nations in terms of your investment philosophy and strategy?
RS: My philosophy is that you ought to distinguish between emerging markets. Emerging markets are 40% of the global economy. That's a very large hunk, and to talk about them as a homogenous entity is just not right anymore. We've got to distinguish between the winners and losers. That's the history of economic development. To me, the strategy for the coming years [will] be to make country bets, to figure out which are going to rise and which are going to flop. Most important, we have to be wary of extrapolating that just because some countries have done well for the past 10 years [means] that this can go on endlessly into the future.
