The “year of the dragon” in 2012 certainly didn’t disappoint, as the global markets battled one financial dragon after another. From the Eurozone’s sovereign debt crisis to persistently high unemployment in the U.S. and a mayday call from many who worried that China’s growth rate was headed for a “hard landing,” 2012 certainly was interesting. As we turn the calendar page to 2013, the Eurozone seems to be in less-critical condition and China’s economic growth still appears to be flying but as of this writing, the U.S. debt problems still haven’t been solved. From my vantage point, the uncertainties surrounding the U.S. economy may just be the tip of the iceberg, threatening the global economy in the coming year. Nevertheless, with every new dire warning of economic disaster the global equity markets generally continued to power away in 2012.
The Ripple Effect
In this interconnected world, what happens in the key economies of the U.S., Eurozone, and Japan this year will almost certainly impact the global economy at large, but the ebb and flow of action and reaction is shifting. Emerging markets, for instance, are generally lessening their trade dependence on the U.S. and Europe, and there are other countries that can drive global growth—some of which may even surprise us in 2013. In addition, a likely continuation of easy monetary policies in the developed markets this year could result in more investment dollars into global equity markets including emerging and frontier markets.
Emerging markets in general have had three characteristics in their favor: generally high economic growth rates, large amounts of foreign reserves and low foreign debt. Many emerging economies appear to be on the cusp of consumer booms as well as productivity advances, which should bode well for future growth potential.
As a long-term equity investor, I am optimistic about the global outlook, despite debt problems plaguing the U.S. and Eurozone. The middle class is growing in many emerging markets, and with it, the potential to fuel a consumer spending boom; the numbers in developing and Southeast Asia look particularly compelling to us. The latest estimates from the International Monetary Fund project developed economies as a whole to have achieved GDP growth of only 1.3% in 2012, with growth expected at 1.5% in 2013. In contrast, emerging Asia is expected to post an estimated GDP growth of 6.1% in 2012 and 6.8% in 2013.1
I’m particularly optimistic about the investment potential in the frontier markets, the lesser-developed of the emerging markets. As exciting as they can be, one must be selective and very patient when investing in these markets. At Templeton we look out well beyond one or two years, and generally take a five-year view. Growth rates in many frontier markets exceeded those of developed markets by a wide margin in 2012, and I believe that trend is likely to continue. The IMF has projected that during the next five years, 10 of the 20 fastest-growing economies will be in Sub-Saharan Africa, and two in North Africa. None are in the Western Hemisphere.2
I anticipate growth in many frontier countries’ capital markets, too. Some of these markets are moving from small and illiquid to large and liquid.
Overall, as frontier market countries expand, they have continued to increase investments in infrastructure, offering investment opportunities in construction, transportation, banking and finance and telecommunications industries. Many frontier countries are leading producers of important commodities such as oil, gas and precious metals, making them well positioned to potentially benefit from anticipated growing global demand for these resources. Rising consumption can provide these economies with strong purchasing power and the ability to spend their way to growth.
Many frontier market countries have continued to be positively impacted by the substantial investments made by large emerging market countries such as China, India, Russia and Brazil. The economic drivers across frontier markets are diverse. For example, Botswana, one of the world’s largest diamond exporters, is introducing call and data processing centers. Kazakhstan, a country rich in oil and other natural resources, is investing in infrastructure development.
Low Interest Rates… and Inflation
Given the fragile state of many of the developed markets right now, it seems likely that central banks could continue pumping money into the system. From an investment standpoint, it’s also possible that investors seeking yield in a prolonged low-rate environment could respond by funneling more money into stocks. I believe ‘quantitative easing’ could be particularly good for emerging markets, at least in the short run, because it means there’s lots of cash in the system. This trend was evident in 2012, as investment inflows into emerging markets equities totaled approximately US$35 billion in the first 11 months of 2012.3 I expect this trend could continue in 2013. With interest rates remaining very low, stocks can look more attractive to many investors.
The flip side of the cash flood coin, of course, is the potential for inflation. In emerging economies, a larger percentage of the population is in lower income brackets, so price increases in essentials such as food and fuel can be harder to absorb. Increased productivity can help lessen the impact of inflation. In order to achieve this, I believe economies with heavy-handed government policies may need to reduce the role of government. Our job as an investor is to scour these countries for individual companies that show potential to be able to survive, and even thrive, in the face of these challenges.
Risks – and Catalysts for Change
One of the biggest risks I see in the year ahead is the ability of politicians in developed markets to take timely, meaningful action to address fiscal policy. If politicians can’t work together and delay any real action, there is a risk that both the U.S. and Europe could slide into recession, erasing much of the gains we generally saw in global equity markets in 2012. Meanwhile, I believe balancing growth, inflation and global competitiveness will be on the agenda for many emerging countries in the years to come.
As we have seen from the events of the past year, there will always be unforeseen factors and circumstances that might become catalysts for greater changes in the global landscape. We cannot exactly predict when the next market correction will hit us nor know how great or small it will be, but we do expect that market volatility is here to stay. However, with every crisis, political change or upheaval, come potential opportunities, too. Therefore, we continue to invest with a long-term horizon in companies that we believe are undervalued, fundamentally strong and growing, and those that we think can weather difficult and changing times.
Happy new year everyone!