08 March 2004 08:15
Spotlight: Rise of the BRICs
Emerging markets equities rallied hard in 2003, as the world economy enjoyed a cyclical upturn and China continued to
grow rapidly. Throughout this period, investors raised their allocations to Latin America, emerging Europe and Asia.
However, while the short-term outlook for emerging markets is indeed encouraging, we strongly believe that investors
should consider their growing importance from a longer term perspective.
Over the next 50 years, the balance of economic power in the world is set to shift dramatically. As part of this
process, our research indicates that the relative size of stock markets will also change, based on several factors:
population growth, technology transfer from developed economies and structural reforms. Currently, the stock markets of
Brazil, Russia, India and China (the BRICs) are only 5% of the size of the four largest markets - the US, Japan, the UK
and Germany (the G4). However, we believe that by 2050, the BRICs' stock market capitalisation could match that of
today's big four.
The three key determinants of the BRIC's stock market growth will be earnings growth, capital raising and
currency appreciation. We believe these factors should exert a strong influence over the next 50 years.
Real earnings growth is driven primarily by real economic growth. A recent study by Goldman Sachs argued that, over
the next 50 years, the G4 nations are expected grow between 1% in Japan and 2.5% in America. Meanwhile, the Brazilian
economy could grow at an average of 3.7%, with Russia at 3.3%, China at 4.7% and India at 5.8%.
Developing economies can grow quicker than developed countries due to faster population and productivity growth. They
can generate high returns on capital, as labour costs are relatively cheap. They can also exploit existing technologies
used in developed economies and their demographic trends are supportive of economic growth. If the BRICs broadly
followed the growth profile of the Japanese economy from the 1950s onwards, their stock markets would grow enormously.
To illustrate this, by the peak of the Japanese market in 1990, the market had grown at an average rate of 9% a year in
real dollar terms since the 1950s.
Projections for growth
The second driver of market size is the raising of new capital, such as the listing of private companies on the stock
market. For the BRICs, the annual growth in market capitalisation due to capital issues since 1993 ranged from 9.4% in
India to more than 30% in China. This was way ahead of the G4 nations at less than 5%. Our projections for growth in the
BRICs' stock markets are based on the conservative view that new issues should grow until 2050 at the historic
30-year annual rate in the US of 2.6%.
The third factor is real currency movements relative to the US dollar. For developing countries, there can be
significant movements in real currency values in the short and long term. The opportunity for foreign investors to earn
a higher return on capital often results in strong capital inflows that drive real currency values higher.
In Brazil, a reduction in the market risk premium may add around 0.5% a year to the dollar value of the stock market.
If Russia becomes the manufacturing and resource centre for Europe, this could add 1.5% a year to the size of
Russia's stock market, similar to the appreciation of the German mark since the 1950s. Meanwhile, for India and
China, we believe that an experience similar to that of Japan since the 1950s is possible, worth an additional 2.3% a
year to their market capitalisations.
So, how would this translate into stock market size by 2050?
Our analysis concludes that the Brazilian and Russian markets could grow by a real rate of around 7% a year in dollar
terms, while India and China may achieve close to 10% growth. This means the BRICs' markets could be nearly as
large as the G4 stock markets by 2050 and implies an enormous shift in the balance of stock market power. While there
are localised risks to our hypothesis, we believe our assumptions are sufficiently cautious to allow for occasional
setbacks.
This growth outlook opens up an exciting era for stock market investment. It will also impact on how investors
orientate their portfolios, not just as a short-term trade on the business cycle but also as a small but growing part of
their long-term savings. Of course, there are risks involved in investing in emerging markets, such as higher volatility
and their economies are prone to occasional shocks. It is important that these risks are managed effectively. Investors
should be careful to diversify their portfolios. They should also employ a well-established fund manager with
experience, expertise and sound research capabilities. By implementing appropriate risk controls, investors can reap the
rewards of investing in emerging markets while minimising the downside risk.
Andrew Milligan is head of global strategy at Standard Life Investments
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