x Abu Dhabi, UAESaturday 22 July 2017

UAE’s emerging market upgrade reflects ratings inconsistencies

Emerging markets rode out the last global crisis well and fared much better than their developed market counterparts until starting to slide this year. But what caused them to succeed in the first place and are the good times over?

A trader at the Dubai Financial Market. Some emerging market countries now have risk profiles similar to that of a developed country. Kevin Larkin for The National
A trader at the Dubai Financial Market. Some emerging market countries now have risk profiles similar to that of a developed country. Kevin Larkin for The National

Emerging markets were one of the big surprises of the 2008 credit crisis with how well they withstood the chaos that swept the financial markets.

While their developed counterparts buckled, emerging markets soared to stellar heights before starting a downward dip once more this year.

So where does the emerging market success story start – and is the party now over?

The term “emerging markets” was meant to capture countries that fell into the gap between an underdeveloped and fully developed nation. As the dynamics of world finance shift and developed nations lose their spotless credit ratings, it is easy to see the label has some shortcomings.

An emerging market country typically displays the following features: a large population with a young workforce; politically and socially transitioning; rapid economic growth; high saving to debt ratio – that is, the population is generally characterised by a tendency to save.

Developed countries tend to follow this trend only during a recession.

Such an extremely simplistic outline presents a few contradictions. Developed countries are the ones with the high credit ratings – but currently display extremely poor or static growth, while it is the emerging market countries with their poor credit ratings that show healthy growth.

For example, in June, MSCI upgraded the UAE from frontier market to emerging market status. It seems a paradox for a region as well-developed as the UAE, with GDP growth of 4.4 per cent per annum last year to rank lower than the United Kingdom that managed only a rate of 0.3 per cent for the same period.

Jan-Benedict Steenkamp, the author of Brand Breakout: How Emerging Market Brands will Go Global, believes the bracketing together of emerging market countries presents a challenge for their industries.

“Emerging markets come in different shades. The challenges remain somewhat the same though,” he says.

“One would also need to be convinced that a brand from a more highly developed emerging market is good quality.

“Of course Etihad and Emirates are examples of companies that have done just that,” he adds.

Examining the case of the UAE, the inconsistencies of the term “emerging market” becomes clear.

The UAE provides ample opportunity for investment and has a workforce that is young and dynamic. With traditional job markets such as western Europe and America grinding to a halt, young graduates and seasoned professionals alike are flocking to the UAE for work.

The Gulf states are doing so well they can easily afford to invest in other countries and indeed they have acted as an economic lifeline for many developed market countries.

And yet up until recently the UAE was a frontier market, not even an emerging market.

Once upon a time, investors looking for safe, modest returns stuck to the developed markets and, most importantly, their government debt bonds, the packaged products that sold off pieces of a government’s debt for a steady return. They were considered an almost fail-proof investment.

Then the crisis hit. As the situation in Greece, Portugal, Spain and Italy has shown, given the right circumstances, a developed market’s bond offerings can go from safe to toxic and even the country itself can be downgraded to emerging market status from developed market, as was the case with Greece.

The emerging markets no longer seemed like such a bad investment option – if you were going to take a risk, why not take a risk that would get you a substantially higher return? Besides, some emerging market countries now have risk profiles similar to that of a developed country.

Post-2008, emerging markets were no longer the preserve of hedge funds and cowboy investors and became attractive to cross-over investors too. It seemed like nothing could stop them.

And then this year jittery investors began jumping ship once more.

Take a look at some of the problems emerging markets face. For a start, they are all bundled together, meaning a country such as Bangladesh sits in the same bracket as China.

No economy can continue to grow forever and even economic powerhouses such as China are now showing signs of slowing thanks in part to the one-child policy. China’s population curve is changing and set to age fast unless there is a policy change.

Another problem the country faces as an emerging market that relies heavily on export is the poor image of the “Made in China” stamp.

Mr Steenkamp does not see this as an insurmountable problem if handled correctly.

“Very rapidly, China is losing its edge as a place for low-cost manufacturing. To counter this, ie, to be able to charge higher prices, they need to develop their own brands. If they don’t do it, they will be in trouble,” he says.

“The most important route is to show consumers the quality of product is much better than thought. By progressively increasing quality and price, they can climb up the value ladder.”

Despite the poor returns, developed markets still attract investment because of their monetary quality. During times of economic crisis, fiscal easing is not so easy for emerging markets compared with developed markets.

However, Nick Pardini, a managing partner of the equity hedge fund Nomadic Capital Investors, believes this fiscal easing has created a credit bubble that cannot last.

“The only reason that developed countries’ stock markets such as the DAX, Nikkei, and S&P 500 have posted large gains for the year is due to ultra loose monetary policy and the resulting credit bubble created by negative real interest rates, not any significant improvement in economic growth.,” he says.

“Once the credit bubble from easy money fades, expect stocks in developed markets to crash.”

When the markets are uncertain this usually leads to a sell-off of emerging markets. Observers such as Mr Pardini regard these dips as temporary.

“Emerging market equities tend to lead in terms of market direction for stock markets globally, so they will be the first to incur losses during a major market correction or crash.

“However, they will also be the first to recover and appreciation will be much greater than the S&P 500.

“During the financial crisis emerging market stocks bottomed out in November 2008, four months before the S&P 500 did in March 2009,” he says.

“Emerging market economies also have much better long-term growth prospects due rising incomes and low levels of personal and sovereign debt on the countries’ balance sheets. They are also trading at much favorable valuations than US stocks.”

It would seem that, in the long run, we may indeed be looking at a permanently altered new investment horizon, with emerging markets now offering the real value.

With their young and innovative workforces, emerging markets are expected to change the shape of the corporate world.

Finance is a patient beast and the next 20 or 30 years will probably belong to fresh markets and their new ideas.

business@thenational.ae