The reformers are the performers

Emerging markets (EM), a bona fide disappointment in 2013, have cruised back into favour this year, and one of the biggest spokes in the wheel of the turnaround has been election reform. Actual and prospective changes in political regimes in India, Brazil, Indonesia, Turkey and Egypt have helped to boost returns in 2014, swinging EM returns to 6.1% as of June 30, roughly in line with developed markets. And this could be just the beginning.

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Emerging markets (EM), a bona fide disappointment in 2013, have cruised back into favour this year, and one of the biggest spokes in the wheel of the turnaround has been election reform. Actual and prospective changes in political regimes in India, Brazil, Indonesia, Turkey and Egypt have helped to boost returns in 2014, swinging EM returns to 6.1% as of June 30, roughly in line with developed markets. And this could be just the beginning.

By Gaurav Mallik

Emerging markets (EM), a bona fide disappointment in 2013, have cruised back into favour this year, and one of the biggest spokes in the wheel of the turnaround has been election reform. Actual and prospective changes in political regimes in India, Brazil, Indonesia, Turkey and Egypt have helped to boost returns in 2014, swinging EM returns to 6.1% as of June 30, roughly in line with developed markets. And this could be just the beginning.

Over 40 top elected officials around the world face voters this year, with several elections potentially ushering in market-friendly policy changes. Investors wondering how, and if, to re-enter the EM asset class may have finally found their inflection point.

Emerging markets could follow the same road as some developed nations that have instituted a bevy of structural changes. For example, Spain’s economy continued to expand in the first quarter of this year, driven partly by government reforms in the labour market and the public pension system. This, combined with the European Central Bank’s continued commitment to purchasing Spanish debt through its Outright Monetary Transaction bond-buying programme, have prompted record low 10-year Spanish benchmark yields of 2.5%[1].

Brazil is a startling example of an EM country that has seen sharp market movements in response to the mere possibility of reform. The MSCI Brazil index has underperformed the broader EM Index each year since 2010, posting an annualised three-year net decline of -6.91% as of June 30[2]. A low growth rate, risks for power rationing in the country’s troubled hydropower system and high inflation have all weighed on the administration of current President Dilma Rousseff.

However, equity performance swung sharply in March in lock-step with a poll reporting a decline in the popularity of Rousseff, who is set to face an election cycle beginning in October. A June poll showing a further drop in Rousseff’s approval ratings spawned another strong run-up in the MSCI Brazil index.

Similarly, after Narendra Modi swept into office in May, overturning India’s long-reigning political dynasty on the basis of promises to boost the economy and create jobs through intense economic reform, Indian markets soared 20%[3]. Interestingly, markets rallied in the same way in 2009 when the Congress Party last notched a national victory. Then the hope was for political stability.

Investors are often struck by how immediately reforms impact EM stock markets. When news of reform is released, stock prices frequently move right away – and sharply. However, reform-related cash flows can only materialise if new reforms are sustainable. In countries like India, markets are waiting to see if the reforms indeed have legs, and how cash flows react over the long-term.

There is one factor that might play into the sustainability of today’s reforms. On average, EM politicians are staying in their posts longer. In 2000, the average tenure was two to three years. In 2014, that number climbed to eight to 10 years, which should give the new wave of reforming leaders more time to make changes stick.

To date, the ‘reformer-performer bounce’ in large EM economies has been forceful enough to lift the entire index. The major question is whether the trends we’re seeing are sustainable. As such, investors will probably want to be increasingly selective in their EM allocations, seeking out managers with the flexibility and local know-how to choose stocks in the countries and sectors where reform plants the deepest roots. As such, active managers who can read the signals on the ground will likely give investors the best chance at gaining value from EMs once again.

[1] Bloomberg.

[2] MSCI Brazil Index, net.

[3] Bloomberg.

 

Gaurav Mallik is managing director of the active emerging markets investment team at State Street Global Advisors

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