Growth shifts to inflation

I view 2010 as a year of economic resurgence. Many emerging markets recorded strong GDP growth as they continued to recover from the impact of the 2008 financial crisis. In several cases, robust domestic consumption, government expenditure and intra-regional trade offset weak external demand from developed markets. This led many countries in Asia and Latin America to return to pre-crisis growth levels much faster than expected. China and India were among the world's fastest-growing major economies during the year, with China overtaking Japan as the world's second-biggest economy halfway through the year.

1. Following the unprecedented fiscal and monetary expansion implemented globally in 2009, the focus for a number of major emerging economies shifted in 2010 from stimulating growth to managing inflation. Concerns about economic overheating and inflation in major economies such as China, India, Brazil, and most recently, South Korea, led authorities to steer toward the normalisation of fiscal and monetary policies.

In an environment of low interest rates, especially in developed markets, ample liquidity and the search for higher returns, I think 2010 may well end up being a record year for investment inflows into emerging markets. Emerging market portfolios attracted $73 billion (Dh268 billion) just in the first 10 months of 2010, on track to exceed 2009's total of $83 billion.

2. Fund-raising by companies in emerging markets via initial public offerings and secondary issues was at a historical high this year. Emerging market companies raised $406 billion in initial public offerings and secondary equity issues in the first 11 months of the year, significantly higher than both the $236 billion raised in 2009 and the previous record of $388 billion in 2007.

3. While emerging economies strengthened in 2010, most developed economies lagged as they remained burdened by high fiscal deficits, weak economic growth and unemployment.

A few economies in the Eurozone were especially at financial risk due to their large budget deficits, with the financial stability of Greece, Spain, Portugal, Ireland and other European countries causing concern. As you have probably already seen in the headlines, to avoid sovereign debt defaults, Greece and Ireland received billions of euros in financial aid from the European Union (EU) and the International Monetary Fund (IMF) in May and November, respectively. Meanwhile, investor confidence in the region continued to be fragile on expectations that Portugal and Spain may also need financial support. In the US, the Federal Reserve announced a second round of quantitative easing in November to inject even more liquidity into the domestic economy.

After rising nearly 80 per cent in 2009, emerging stock markets, as represented by the MSCI Emerging Markets Index, were up 11 per cent in US-dollar terms in the first 11 months of 2010. However, equity prices experienced significant volatility throughout the year, as did exchange rates and commodity prices.

Argentina, although a somewhat small and restricted market, was one of the top performers, returning close to 70 per cent in US-dollar terms for the year to end-November, as investors anticipated long-overdue market reforms after the death of former President Nestor Kirchner.

Another strong performer for the 11 month-period was Thailand, with a 51 per cent return in US-dollar terms, as investors focused on the strong fundamentals of the market and chose to overlook the political turmoil earlier in the year. Other strong performers included Chile, Colombia and Peru in Latin America, Indonesia and Malaysia in Asia as well as Turkey in Europe.

4. I believe emerging markets are now in a secular bull market, and as discussed below, I expect this trend to continue into 2011. Even more money is likely to be directed into these markets as investors around the world realise that emerging economies on average are growing three times faster than developed economies, and generally have more foreign reserves and lower debt-to-GDP ratios than their developed counterparts.

The International Monetary Fund has estimated that emerging markets will grow an average of 7.1 per cent in 2010 and 6.4 per cent in 2011, well above the 2.7 per cent and 2.2 per cent growth (in 2010 and 2011, respectively) estimated for developed markets. Meanwhile, foreign reserves in China are the largest in the world, totalling more than $2.6 trillion. Similarly, Russia has more than $450 billion, while India and Brazil have more than $250 billion each in reserves.

Impact

5. Although the slowdown in the global economy had an impact on some emerging markets, we are seeing that these economies are becoming more domestically driven. Private domestic consumption and government expenditure in areas such as infrastructure have at least partially offset the impact of decelerating export growth. The services sector has, in our view, also been gaining in importance, especially in China and India. Generally, I believe that the economic recovery in emerging markets is likely to be sustainable in view of their strong fundamentals. In addition to robust macroeconomic data, financial and fiscal indicators remain positive.

Moreover, the search for higher returns in a low interest rate environment coupled with attractive valuations in emerging markets could continue to support equity prices. However, emerging economies may face inflationary pressures from the capital inflows spurred by continued loose monetary policies in developed markets.

In addition, if central banks in emerging markets continue to buy dollars to prevent their currencies from appreciating too quickly, thereby increasing their foreign reserves, they may appear increasingly safe to investors looking for markets with higher economic growth and yields.

This may lead to a "vicious cycle", which could have some untoward consequences and therefore, this buying activity needs to be watched carefully.

The writer is Executive Chairman, Templeton Asset Management Ltd.