Realism after years of emerging- markets euphoria
The past wasn't linear, and the future won't be linear either.
In a nutshell, that's the core argument of Breakout Nations, a book by Ruchir Sharma, head of emerging market equities at Morgan Stanley Investment Management.
After 20 years of slogging around the world's developing countries, Sharma has no time for the catchy acronyms and neat growth theories peddled by investment bank salesmen over recent years.
As a result, depending on your point of view, his book will come either as a welcome blast of realism, or as a bucket of cold water tipped unceremoniously over some of your most cherished investment beliefs.
Sharma maintains that continued fast growth in emerging markets and their rapid convergence with developed economies is anything but inevitable.
Instead he argues that the spectacular period between 2003 and 2008, which saw a dramatic acceleration of growth rates right across the world's emerging markets, was a one-off aberration.
Rather than the beginning of an irreversible trend, he says this undifferentiated pick-up in emerging-markets was driven by a massive influx of liquidity, propelled by rock-bottom interest rates in the developed world. Now, with risk aversion at new highs, the tide of liquidity is receding. As a result, the synchronised rapid growth before the financial crisis is unlikely to be repeated.
Happily, there will still be winners among the emerging markets, it's just that they may not be the ones investors expect.
Consider China. 'China boomed the old-fashioned way,' Sharma writes, by shifting under-employed peasants to more productive jobs in urban factories, by building roads and ports to export the goods those factories produced, and by investing in telecommunications.
It was a great model while it lasted. But the pool of surplus rural labour has almost run dry, and wage costs are rising. At the same time, with China's total debt level approaching 200 per cent of GDP, investment is slowing.
Sharma expects growth rates of between 6 per cent and 7 per cent in the next few years. That's still impressive, but bad news for investors, as many companies have struggled to generate profits at growth rates of 8 per cent or more.
He strikes a similarly sceptical note when examining other popular emerging markets.
In India, he notes that the reforms of recent years have been aimed less at generating wealth than at redistributing it through higher government spending. That risks exacerbating inflation, crowding out productive private-sector investment and entrenching political cronies as business barons.
Even so, Sharma reckons that India still has a 50 per cent chance of achieving the desired 'breakout' status over the coming years, thanks to its regional diversity and vigorous entrepreneurial culture.
He is far less positive about Brazil, where government taxes and social spending have hit European levels, and where the recent strength of the currency has eroded the competitiveness of all but a handful of commodities-based industries
And he scents trouble in Russia, where wealth is increasingly concentrated in the hands of a small elite in league with an ever-more-authoritarian leadership.
Sharma does see some bright spots. Among them are opportunities in Turkey, as well as in Southeast Asia, which he argues is growing more competitive thanks to rising wage costs in China and an appreciating yuan.
Sharma proposes no catch-all methodology for picking winners among the worlds emerging markets. He does, however, offer a few 'rules of the road', based not on economic theory, but on years of on-the-ground experience.
For example, he closely scans the rich lists of emerging economies, avoiding those countries where wealth is most concentrated (see the first chart below) or where there is relatively little turnover among the top 10 billionaires, both of which may indicate a culture of cronyism and vested interests which threatens to stifle business innovation.
He also keeps a close eye on local prices as an indicator of competitiveness. If a night in an executive hotel costs double the emerging market average (second chart), it is a worrying sign that the economy is no longer competitive.
Breakout Nations is not a particularly cheerful book. It does, however, inject a much-needed dose of realism into emerging-markets investment, after a long period of optimism that sometimes bordered on the euphoric.