It is ten years since Jim O’Neill, then top economist and now Head of Asset Management at Goldman Sachs, put forward the thesis that the four emerging economies Brazil, Russia, India and China – BRICs, as he dubbed them – would overtake the G7 by 2050. O’Neill’s catchy acronym enjoyed enormous success in the financial world.
The sums invested in dedicated BRIC funds reached USD 70 billion at times. But the equity market performance of Brazil, Russia, India and China in their 10th anniversary year was anything but sparkling.
Short-term flops, long-term tops
The BRIC countries all boast solid government finances. They have used their economic growth over the last decade to run down their public debt. Brazil’s debt ratio is the highest of the four but is still a fairly modest 55% of GDP. Nevertheless, the BRIC equity markets were among the big losers in crisis-torn 2011. With a loss of 22%, they did much worse than Europe (–8%). They were even outdone by the broader emerging markets index, which ended the year with a minus of 18%.
The BRICs fell victim to investors’ escalating aversion to risk, as has happened not infrequently in the past. Last year a total of around USD 40 billion was withdrawn from emerging market funds. There is also a macroeconomic dimension. The emerging markets are still heavily dependent on exports and therefore closely affected by economic trends in the industrialised world.
On a long-term view, however, the BRICs compare well with other equity markets despite their recent malaise. While markets in the industrialised world have largely moved sideways over the last ten years, the BRIC index has climbed more than threefold in US dollar terms.
Inflation erodes corporate profits
Notwithstanding these long-term advances, short-term setbacks are always a possibility. These markets are susceptible not only to external factors but also to home-grown problems. The knock-on effects of China’s expansive monetary policy after the outbreak of the financial market crisis are still being felt. China took stimulatory action to shield itself from the recessionary impact of the floundering industrialised eco-nomies. Monetary easing pushed up money supply by a year-on-year monthly average of 26%. Recession was successfully avoided, but the result has been an acceleration of inflation over the last two years. The authorities reacted by tightening monetary policy again, but the hoped-for stimulus from exports failed to materialise because demand from the beleaguered industrialised countries was too feeble.
Companies in the emerging economies were able to increase their sales more strongly than others in 2011 but were unable to pass on cost increases in full. As a result, profit margins were squeezed. This effect was most noticeable in Brazil and China, where inflation is especially high.
Investors’ risk tolerance and inflation trends will again be key factors affecting the share price performance of the emerging markets in general and the BRICs in particular in 2012. Tighter monetary policies are now dampening inflation, and this effect is being supported by weaker economic momentum. That gives the central banks increased room for manoeuvre (see page 15). Governments have been prepared to assist the central banks with back-up measures in the past, though these have often involved burdens for companies and hence for shareholders.
Central governments have been particularly ready to exert their muscle power in the energy sector. In order to curb inflation, the Brazilian oil company Petrobras was forbidden to raise petrol prices at the pumps for three years in succession. The Russian company Gazprom has been forced to supply Moscow’s allies with cheap gas. Both companies have been partly privatised, but political influence is still strong. Before taking up their present positions, Brazil’s President Rousseff and Russia’s President Medvedev were sitting on the boards of Petrobras and Gazprom respectively. Governments will continue to exploit these devices in future – especially if inflation fails to decelerate as much as expected.
What next?
If worries about inflation and a hard landing in China subside and the debt crisis comes off the boil, the BRIC equity markets should enjoy a recovery. Valuation ratios have fallen steeply and are now close to historical lows. Three of these markets are trading at less than ten times expected corporate earnings for 2012: Russia (4.6), Brazil (8.6) and China (9.1). The price-earnings ratio in India is 13.3. On an index-weighted basis that gives an overall p/e of 9.1 for the BRICs, compared with 13.0 for the rest of the emerging markets. However, the undervaluation against the industrialised countries, which was a major driver at the start of the last decade, has now been largely corrected.
With the industrialised economies faltering, stimulus from the export sector will decline. At the same time there is growing competition from “new” emerging markets that are copying China’s export-driven model. In order to achieve strong profit growth, the emerging countries must intensify trade among each other. Asian countries also have the possibility of strengthening domestic consumption. Even so, it will be difficult to repeat the performance of the last ten years.
Conclusion
The BRIC economies have firmly established themselves in the world economy, and their equity markets have become an important part of the global financial landscape. BRIC shares should have in a firm place a diversified equity port-folio. But we recommend that emerging market investments should not be confined to these four countries alone. Investors are advised to take a broader position so as to tap the potential of smaller high-growth emerging markets and diversify their exposure to country-specific risks.
Dr Jörg Zeuner is Chief Strategist and Chief Economist at VP Bank Group in
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