May 17, 2013

How to Spot a Breakout Nation

Looking for the next hot emerging market? Two indicators can point you in the right direction — but two others will lead you astray.

Sharon Kahn
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When it comes to gauging an emerging market’s chances of success, Ruchir Sharma looks beyond the usual data points — and ignores a few standbys altogether. Sharma, head of emerging markets and global macro for Morgan Stanley Investment Management, spoke at the Sir Gordon Wu Distinguished Speaker Forum last month and offered these pointers:

What Doesn’t Work: Long-Term Forecasting

Portfolio managers are fond of advising clients to put money into an investment and leave it to grow. But Sharma accuses forecasters who go beyond three to five years of arrogance. “The super-long view is being popularized largely by economic historians and commentators and has become faddishly influential in business circles as well,” he wrote in his bestselling book Breakout Nations: In Pursuit of the Next Economic Miracles (2012, W.W. Norton). Trying to identify a future breakout nation by examining forecasts that reach to 2050 is pure folly, he says.

What Doesn’t Work: Demographics in Isolation

Analysts who extrapolate China’s success to other markets often point to its particularly large generation of young people entering the workforce just as its financial rocketship took off. But that generalization doesn’t apply to most developing markets, he says. “These forecasters often assume that these workers have the necessary education and skills to be employable, and that governments will find gainful employment for them.”

Instead of making sweeping assumptions, Sharma advises emerging market investors to burrow into the details of each individual country. He puts particular emphasis on:

• per capita income levels (it’s easier to grow income from $1,000 to $2,000 than from $5,000 to $10,000),
• travel habits of local businessmen (moving money home rather than offshore is a sign of confidence),
• debt levels relative to GDP (countries paying too much in interest can’t invest in the future) and
• the importance of second cities (oversized capitals may indicate excessive power in the hands of politicians).

What Works: The Billionaires’ Index

To create a sustainable growth pattern, a country must share its wealth among a large number of citizens and be competitive among its peers. Sharma follows two somewhat colorful indicators to get at those truths.

One he calls “the billionaires’ index.” As Sharma explained, "If a country is generating too many billionaires relative to the size of the economy, it’s off balance.” Simply put, if wealth is not shared, it is difficult for a middle class to develop. He’s also concerned about how billionaires got there. “Ideally they should emerge predominately from productive economic sectors, not cozy relationships with politicians.” And he likes to see some churn from year to year, with new names appearing. Competitive newcomers shaking up the list “shows creative destruction,” he wrote.

An example of a country that fails that test — miserably — is Russia. “Russia has more billionaires than anywhere in the world after the United States, but it’s not even in the top 10 among countries with millionaires,” he wrote. In 2011, the latest figures available, Russia’s 100 billionaires make up nearly 30 percent of the country’s GDP. Other countries with lopsided billionaire representation include Malaysia, India, Taiwan, and Mexico.

What Works: The Four Seasons Index

Sharma devised “The Four Seasons Index,” which compares the cost of a night’s stay at a luxury hotel in various cities as a proxy for competitiveness. His rationale: The currency of commodity-exporting countries has inflated with the boom in oil and metal prices. That, in turn, has pushed up the price of other goods and services — including hotel rooms — which he said can tell a lot about a country’s competitiveness in world markets.

Using the 2011 emerging market average cost of $441 as a baseline (the developed market average was just over $700), he learned that “commodity capitals like Moscow [where a night at a luxury hotel costs $924] and São Paulo [$720] have been pricing themselves so far above other major cities, they are putting their future growth at risk.” In comparison, a night at the Four Seasons in Jakarta, capital of another commodity exporter, remains “strikingly reasonable” at $230. Shanghai’s Four Seasons ran to $359. Other bargains: Bangkok ($234), Kuala Lumpur ($160), and Colombo, Sri Lanka ($156).

Calling the success of emerging markets in the last decade “freaky,” Sharma does not expect all developing nations to grow at nearly the same clip. But he does expect breakout nations to perform better than expected, and better than their peers. As the price of oil and other commodities fall, he expects commodity importers such as the Philippines and even Poland to surprise on the upside, while exporters such as Brazil, Russia, and South Africa may disappoint. And, “as some of the big emerging markets lose their luster over the next decade,” he wrote, “the United States could appear quite resilient in comparison.”

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