RockCreek, a global investment firm, hosted an interesting panel discussing the market dynamics and economic factors shaping emerging markets today. The guests were Richard Lawrence, the founder of Overlook Investments, and Indermit Gill, who is the chief economist of the World Bank.
Some of my notes from the session are included below (these are for personal reference only and not intended as a comprehensive transcript; any mistakes are my own).
Growth outlook for emerging markets – are we transitioning to a new normal?
Indermit Gill (IG): It is very difficult to answer that question. If you look at the longer term growth potential of emerging markets and developing economies, it it not that there has been a sudden change, more of a steady decline over the last 20 years with perhaps some acceleration [of that decline] in the last 2-3 years. If you look at the first decade of this century, the potential growth of emerging markets was around 6%. If you look at the next decade (2011-2020), it was 5%. And if you look forward from 2023-2030, the potential growth rate is less than 4%. Some of that is China, where you do see a decrease in potential growth. But if you look at India, Indonesia, these have also steadied out at 5-6%. Brazil, Mexico, South Africa – much lower potential growth rates, but their problem isn’t that they have come down but that they have been relatively low all the way through. So it does look like there is a “slower growth” normal for emerging markets and developing economies. Within that, there are potential opportunities in places like India, Indonesia etc. but he doesn’t think that can be to the exclusion of China. Even if China’s growth rate slows, the GDP base is much larger, so the absolute amount of economic output that China is contributing to the global economy will still be double that of the previous decade.
Richard Lawrence (RL): As a stock picker, his team at Overlook are very macro aware, but the investment decisions are really driven by individual companies. Through his 40+ years of investing, he has always felt it is very difficult to see, at a company level, the difference between 2% GDP growth and 5% GDP growth. It really depends on the company and how they are executing. The growth rates across Asia are still very good for them. As an example, the earnings of their portfolio companies over the next 3-5 years are expected to grow at ~13.4% p.a., well in excess of what the nominal GDP growth rate would be. He doesn’t disagree that we will see slower growth but doesn’t think it will impact the outlook for equity investing in the region, that is much more driven by individual stock picking.
Impact of changing demographics, specifically with regards to China?
IG: You can divide up the potential growth decline into 3 components: labor, investment and productivity. When he looks at the China numbers, if you are looking 10-20 years out, he thinks the part about demographics is pretty overblown. If you look at the contribution of labor to growth in the case of China, it was pretty low even back between 2000-2010. It then went to 0 in the last decade and it will stay at 0 over the next decade or so. What is much more worrying to him is you see a massive drop in productivity. China’s investment/GDP ratio will go down and they think that is a good thing but the worry is productivity growth dropping pretty much in step with that decline.
RL: Overlook’s portfolio has about 20-22 holdings, half of that is in China. They continue to see really good productivity coming out of their companies there, including an enormous amount of automation, which is almost scary if you think about the unemployment rate for young people in China. But they don’t have to be invested in every company or SOE in China. What concerns him more about the demographics is that real estate has long been the asset of choice for Asians to invest in. And while it looks like home ownership is really deep in China, his guess is it is much shallower but a lot of people have multiple apartments. Until they get out of them, it is difficult for them to have an appetite to invest going forward. They saw this very clearly in 1997/98 in HK. So the tricky part for China is managing their way through a need to stimulate and not stimulate property (which is ~25% of the economy). However, they do have the capability to be very specific in the allocation of their stimulus and they will need to be.
IG: China has been very good at stimulus, but it was always through the public investment channel and not through the private consumption channel and they are having a hard time making that switch. The drop in potential growth for China from ~8-9% to ~4-5% is a natural thing because China has grown really rapidly, it has gone from essentially a lower-middle income country to almost a high income economy. If there is a smooth transition from the high growth path to the low growth path, it’s not a problem, the problem comes if that becomes a more choppy or it becomes much more sudden.
Thoughts on the potential impact of AI on productivity?
RL: In terms of seeing it have an actual impact on companies, we are still very early. Even at Overlook, everyone is using some form of machine learning and AI to make them more productive, including the ability to process more data. But processing more data does not directly lead to having a better portfolio or better stock picks. There are lots of advantages to AI, but at a wider scale, they have not seen enough yet. Many of the investments available to people like them are much more speculative at this point, and they are not good speculators on new technologies. They will let it go up and then come down and when the wash out comes, that is generally when they get involved.
Implications of China/US trade war, opportunities for the rest of Asia?
RL: The world got more complicated when the trade war started. The massive efficient machine that was Southern China initially and then Eastern China, all of that had to get restructured. To them, it meant higher capex overseas, higher costs overseas, less efficiency overseas and higher global inflation coming out of the deglobalization. The next piece, as you look at companies, is that you have to look for the imbalances. One example he can point to 6 months ago is when Apple had ~95% of their manufacturing in China. That is an imbalance. It even put the security interests of the US at risk. So you have to get your supply chain restructured to really get in balance. Seeing big efforts now underway that will be a decade long process. If you look at TSMC, they are building plants around the world to get their physical presence more back in balance. They talk a lot about this with their portfolio companies but it is a complicated process. Not everyone can be a component manufacturer in China and then suddenly be a component manufacturer in 5 different countries, while also maintaining your investment in R&D.
Reshoring in India?
IG: Starting to happen, but still relatively small. If you look at India’s FDI regime, perhaps the biggest restriction are the equity restrictions. India is about the worst there, alongside the 3 SEA economies (Indonesia, Malaysia, Thailand to some extent). Vietnam and Mexico do really well on that metric. But when you look at a big country like India, you ultimately have to disaggregate it to the state level. His observation is that the states have not picked up the speed. He senses an urgency in New Delhi, but doesn’t sense it at the state level, except for maybe 1-2 states. Private investors will probably look for a good coincidence of central government reforms and state government reforms.
Thoughts on valuations in India?
RL: Overlook is not investing in India. About 2 decades ago, he decided he was going to invest in China and he took on an economy with 1.3bn people at the time. To take on another market of 1.3bn people, just thinks there is a limit to what they can manage. India has done extremely well, China has done extremely poorly. His natural inclination, as an eyes-open contrarian, is that they are more interested in China.
Emerging markets outlook, catalyst for foreign buyers to re-enter?
RL: Need to see a better relationship between US and China, and they are at least talking now. But he is not overly optimistic about foreign capital coming into Asia and driving share prices higher, particularly in China. These are going to be domestic events. We see how the foreigners are leaving HK every single day in selling stocks down. The average American institutional investor still has ~2/3 of their exposure in private equity and venture capital in places like China, can’t get any liquidity out of that, so they are just selling the public equities. Valuations in their portfolio have gone from ~23x earnings down to ~14.6x earnings. They could put together an easy portfolio of single digit P/E companies but that is not where you want to be, you want to be in the leading companies that are growing and have great profitability. He thinks the average US institution he speaks to is still closer to selling out than coming back in, with some exceptions.
When they look at the macroeconomic indicators across the countries they invest in – they have been running current account surpluses since 1997/98, don’t have excessive government deficits, don’t have the inflation cycle that hit the US, they have larger FX reserves etc. So there are not a lot of red lights in the matrix of macroeconomic data they follow saying they should get out of X country. Don’t know when markets turn, but if they can put together a portfolio that is growing at 13%, with 46% operating returns, no debt, with an economy that is cash flow positive with current account surpluses, eventually they will have their day. That’s been the case over the last 32 years where they have gone through all sorts of crises, inflation, banks going bust etc.
What is the solution to China’s slowing growth rate?
IG: In many ways, it might be to go back to what worked previously from the 1990s through the 2000s. It was a move to market. More than 90% of goods and services in China are now intermediated through markets. Those are products. But if you look at inputs (land, capital, labor) – these are intermediated largely through government rather than markets. The solution is in sight, you have to liberalize those markets and you will get much more efficiency. The problem is the political security agenda between the US and China has perhaps overwhelmed the reform agenda in recent years.
Regulatory risk in China?
RL: In their portfolio, the largest risk every single year is regulatory risk – in an average year, it happens in about 2 of their 22 holdings, so it doesn’t happen everywhere, although theoretically it could. It goes back to investing in sensible people doing sensible things – building the largest renewable company in the world that sells the cheapest electricity in China, making noodles, selling medical consumables, most of the time you are largely left to your own devices. It is a matter of picking and choosing and staying away from these hypersensitive areas where the government perhaps feels threatened.