Emerging Markets: Keep an Eye on Reform

Economic reforms remain critical for emerging economies' attempts to successfully transition from low-wage industrial economies to high-skilled, consumption-based economies.

For those economies – and investors – that transition can lead to better economic growth, stronger future earnings, and a lasting, structural improvement over peers. Here, we review the reform momentum across four countries – Brazil, Indonesia, India, and China – and preview South Africa's post-Zuma reform agenda.

  • The global economic expansion, along with reasonable valuations, supports our current preference for overweighting emerging market (EM) equities.
  • Economic reform is a critical component of future economic growth and development in many EMs, and warrants close monitoring.
  • Our preferred EM countries include Brazil, Indonesia, India and China. We describe their reform efforts below. In addition, positive political developments in South Africa bear watching.

Brazil's swings between reformist and populist administrations demonstrate the importance of economic reforms. The prior reform cycle, which began in 1994 under succeeding President Cardoso’s leadership, ultimately stabilized the economy by breaking extreme inflationary expectations. In the following years, which also coincided with stronger commodity prices, Brazilian equity markets were a major outperformer across EM equities.1 The populist policies in Luiz da Silva's (Lula's) later years and under President Dilma Rousseff effectively wiped out these gains as market-friendly reforms were replaced with incoherent macroeconomic policies and unsustainable fiscal promises, culminating in a deep stagflationary recession. President Michel Temer offered investors hope after quickly enacting labor reforms, adopting a microeconomic reform agenda aimed at boosting productivity, and addressing fiscal sustainability with a 20 year cap on real spending growth at zero percent.2

However, the spending cap isn’t enough to fully correct Brazil’s fiscal path; that requires pension reform. Pensions account for roughly 45% of total expenditure and are growing 5% annually in real terms.3 At this pace, Brazil's pension spending will consume the entire fiscal budget by 2030.4 Brazil's positive cyclical position – accelerating economic growth, loose financial conditions, and low inflation – has offset declining market expectations for further pension reforms ahead of the October 2018 elections. However, Brazil will quickly need to address its pension system; doing so would arrest the unsustainable fiscal trajectory, possibly leading to lower neutral policy rates. It could also help increase potential GDP through higher investment and productivity increases. The October elections may complicate the timing of reforms, but certainly not their necessity nor the benefits they bring investors.

Brazil vs. Emerging Markets

Brazil vs. Emerging Markets

Source: Thomson Reuters, February 2018. The left chart compares the relative performance of the MSCI Brazil Index against the MSCI Emerging Markets Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.