Key Drivers To Emerging Market Outperformance: Increasing Trends of Economic Freedom, Trade Openness And Rule of Law

US Global Investor's Frank Holmes enumerates six key drivers in favor of a secular emerging markets outperformance over the coming years.

Mr. Holmes writes(black bold highlights his, blue mine) :

1. Rapid Economic Growth: In the coming years, growth in emerging economies is expected to outpace that of the developed world. This growth is fueling an increase in household income in places like China and India where nearly 60 million people—roughly the combined populations of Texas and California—are joining the ranks of the middle class each year.
2. High Savings Rates in Asia: Despite rising consumption, households in emerging Asia save 17 percent of disposable income—that’s roughly four times what is saved in the U.S. and much higher than the developed world. These high savings rates allow them to meet the higher requirements for home ownership—many require at least 20 percent down—and have larger amounts of funds to invest in capital markets.
3. Urbanization: The world’s urban population is growing by more than 70 million people each year. China already has over 100 cities with 1 million people and is expected to have over 200 of them by 2025. This urban migration has overwhelmed existing infrastructure like roads, sewers and electrical grids. The buildout of this critical infrastructure will require vast amounts of copper, steel and increase demand for all commodities.
4. Desire for Social Stability: One main goal of emerging market governments to remain in power is to keep the public happy. They are doing this by increasing personal freedoms for citizens and providing them with opportunities to increase their quality of life. Many governments have found the key to social stability is focusing on job creation which establishes a path of upward mobility for citizens.
5. Natural Resources Wealth: Many of today’s most promising emerging nations sit atop some of the largest oil, metal and other valuable resource deposits in the world. Many of these nations have teamed up with private and/or foreign enterprises to bring these resources to market. Revenue generated through taxation and direct ownership allows for these governments to build infrastructure, create jobs and pursue other economic opportunities.
6. Corporate Transparency: A history of corruption and political turmoil has given way to higher standards of corporate governance in today’s globalized world. Though still far from perfect, the improved transparency and oversight has made important information available to investors and reduced uncertainty. By aligning themselves with international business standards and requirements, emerging nations will attract more foreign capital and better integrate themselves into the global marketplace.

I'd like to add three more important variables.

Although Mr. Holmes did mention in passing about the increasing "personal freedom", it must be emphasized that the respect for property rights serves as the root for economic freedom and trade openness which predominates all the above.

Not to mention the legal "rule of law" framework that underpins social institutions from which all these would be operating on.

In short, prosperity or capital accumulation emanates from economic freedom, trade openness and the rule of law, where all the others are simply offshoots or products of these 'sine qua non' underlying drivers.

Outside the incentives brought about by privatize profits and socialize losses, no rational person will invest in any country or markets where they see great risk from governments' arbitrary confiscation of investor's risk capital.

In other words, it isn't much of the issue of return on investments but the return OF investments.

As you can see below, the reason for the explosive growth in emerging markets has been because of the deepening depth of economic freedom and freer trade relative to the past.

chart courtesy of Moody's/ FT Alphaville

While Moody's expects a retreat, as the reason for the orange dot (arrow from FT Alphaville) I don't share the pessimism.

That's because many, among the emerging markets, have been realizing the benefits of trade, which has started to filter into the political process of many EM countries but whose impact comes at a different scale.


Yet much of the perceived pessimism has been due to the financial crisis which caused a dramatic retrenchment in global trade.

But this seems more of a the blip, though. Most of the disruption had been triggered by the Lehman event, which prompted for a near seizure of the US banking industry, which rapidly escalated across the world. To be sure, it hasn't been due to increased signs of protectionism (as pointed out in this space, example see WTO: Little Signs Of Protectionism).

And the swift recovery in global trade (chart courtesy of finfacts) appears to validate our analysis.

Hence, the trend towards greater economic freedom and trade liberalization in key emerging markets are likely to resume as the main trend and provide the framework as to why emerging markets are likely to outperform developed markets.

Copper Market: The Growing Role of China and Emerging Markets

This is just an example of how the past hasn't been the future or how the present environment has been evolving.

Frank Holmes of US global funds notes of the changes in the seasonal patterns of copper prices due to the growing influences of China.

Here is Frank Holmes, (bold highlight mine)

``The 30-year pattern shows what used to be a rule of thumb when I first got into this business—buy in November and sell in March. This was because of seasonal stockpiling during winter months leading into major building and construction projects in the spring and summer months.

``In contrast, the 15-year pattern is dramatically different. This pattern shows copper prices rising from January through May and then trading pretty much sideways for the rest of the year, with modest peaks and valleys along the way. A similar pattern is drawn to represent the past five years.

``The reason for the trend shift is China.

``According to research from Dundee Wealth Economics, China’s copper consumption grew from about 1.8 million metric tons in 2000 to nearly 5 million metric tons in 2008. This pushed China’s share of global consumption from 13 percent in 2000 to 28.5 percent last year. In the first quarter of 2009, Dundee estimates, China accounted for 38 percent of the world’s copper usage.

``Demand for copper from the other BRIC countries (Brazil, Russia, India and China) has also increased, but none nearly on the same scale as China."

``For instance, Russia’s copper demand increased 300 percent from 2000 to 2008, but its overall share of global demand is still just 4 percent. India and Brazil both saw smaller consumption growth over the eight years, and in 2008 they accounted for 3 percent and 2 percent of global use, respectively."

``Copper isn’t the only metal where China is king. China also lead global consumption growth for aluminum, zinc, lead and nickel from 2000 to 2008."

In sum, China's role in the commodities market have been gaining significant weight in terms of overall global demand, and will most likely increase its role.

To add, we should also expect other Emerging Markets to equally gain market share. At present the BRIC, according to the estimates above, accounts for 49% of the copper market demand.

And as we pointed in Decoupling in Oil Markets: The Centre of Gravity in Energy Markets Has Shifted To Emerging Markets, BP's Tony Hayward observed that the ``centre of gravity in the energy market tilted sharply and permanently towards the emerging nations of the world."

Copper prices has so far reflected the activities in the Baltic Dry Index and the Shanghai Index (albeit the latter continues to zoom).