Welcome to Mongolia: What the S&P Downgrade Means for Emerging Markets

Mongolian Family Uses Solar Energy to Power Home"Nothing may change overnight, but the downgrade may eventually lead to stronger currencies and more fund flows for emerging markets." -- Aarati Krishnan, Business Line Research Bureau Chief, The Hindu

In the almost four months since the Standard & Poor's rating agency issued their negative outlook on long-term U.S. sovereign credit, the world has witnessed a near-total breakdown on Capitol Hill, marked by political posturing, finger-pointing and unimaginable fiscal irresponsibility among the nation's top elected leaders.

The S&P responded to this colossal exhibition of ineptitude by downgrading the United States' long-term sovereign credit rating from AAA to AA+ on Friday. Mercifully, they gave everyone an entire weekend to freak out before the markets re-open, though it shouldn’t have come as a surprise to anyone, even as governments, investors and the international media scramble to figure out the effects of the decision on the world economy.

In their press release, the S&P said, "The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon."

The Eurozone isn't faring much better, unable to stop a debt contagion that seems to have purchased an all-access InterRail pass (the one that includes ferry transfer between Greece and Italy). Economic historian Niall Ferguson, who teaches at Harvard and the London School of Economics, wrote in 2010 that the sovereign debt crisis in Europe was "a fiscal crisis of the western world," adding matter-of-factly, "its ramifications are far more profound than most investors currently appreciate."

So as the rich world markets shudder, what does a chastened America's AA+ status mean for the world's emerging markets?

BULLISH ON BRIC?

"Overall, risk assets, emerging market equities will continue to face painful bouts of volatility owing to the debt impasse in Europe and U.S.," said Mumbai-based Edelweiss Securities in a note issued following the S&P rating downgrade. "This will, in all probability, affect market sentiments in India as well."

But while some volatility across the board is to be expected, considering the coupled relationship of the emerging BRIC economies—Brazil, Russia, India and China—and the U.S. and Eurozone markets, some traders are bullish on the Big Four.

After the S&P issued their negative outlook in April, Brian Kelly, CEO of Brian Kelly Capital, said on CNBC’s Fast Money, "If you're afraid of emerging markets overheating—and I'm talking in particular of India and China because of inflation— if the U.S. is slowing if you cannot borrow anymore and the Fed cannot do QE 4, 5 and 6 because you can't borrow anymore, then inflation should come down. That should be bullish for the emerging economies...particularly China."

LOOKING BEYOND BRIC

In March, Citi issued a note about the work being done by Ebrahim Rahbari and Willen Buiter of the Citi Investment Research & Analysis team (CIRA) in regard to "the potential in a much wider range of markets" than the BRIC countries. Citing both growth in population and per capita income, they identified Asia and Africa as the fastest-growing regions, also suggesting that China will overtake the United States as the world's largest economy in 2020, with India assuming the top spot by 2050.

CIRA's so-called 3G ("global growth generators") list includes Bangladesh, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, the Philippines, Sri Lanka, Vietnam and China, the only BRIC member to make the cut.

"Many countries with emerging markets have reached a threshold level of institutional quality and political stability, and are already positioned well for growth," said CIRA. "For poor countries with large young populations and at an earlier stage of development, a clear path: open up, create some form of market economy and invest in human and physical capital. At that stage, many countries are poised for more growth from a period of ‘catch-up’ and ‘convergence’ with the developed world."

SUSTAINABLE INVESTING IN EMERGING MARKETS

Considering the ongoing fiscal crises in the U.S. and Europe, developing economies present significant opportunities for investors looking to emerging markets with an eye to sustainable investing. And the shift away from the rich world, which has been happening for years, will likely only speed up now as analysts see more than just financial shelter in places far from New York, London and Brussels.

Greg Radford, the Environment and Social Development Director of the International Finance Corporation (IFC), a member of the World Bank Group, wrote in a 2009 IFC report, "The factoring in of ESG issues in investment decisions for emerging market equities is continuing to make inroads into mainstream investment practices, despite the financial crisis."

"The momentum behind ESG analysis is rooted in initiatives such as the Equator Principles for project finance and the UN Principles for Responsible Investment in the pension fund arena," said Radford. "In addition, a new crop of multinational firms based in the emerging markets has caught the increased interest of global investors."

AND NOW FOR SOMETHING COMPLETELY DIFFERENT

As the traditional Euro-American stranglehold on global finance quickly loosens its grip, emerging markets are champing at the bit to enter the breach, having grown steadily for more than a decade.

The current issue of The Economist notes that the U.S. Q2 2011 economic output remains below what it was at the end of 2007, while "emerging economies' total output has jumped by almost 20% over the same period," adding that "almost a quarter of the Fortune Global 500 firms, the world's biggest by revenue, come from emerging markets; in 1995 it was only 4%."

"The crisis enveloping the developed world may force global money managers to take a hard re-look at the emerging markets, where both stocks and bonds appear to be far better bets," said Aarati Krishnan, head of the Business Line Research Bureau at The Hindu, a Chennai-based English-language daily. "It is high inflation and slowing growth, not the very safety of capital, that these markets are grappling with."

Opportunity is one thing, but a flight to safety in emerging markets? At first blush, the concept may sound a bit odd. But considering that not too long ago, it seemed that America’s AAA credit rating was as solid as the gold in Fort Knox, it has become abundantly clear that these are strange days. And, at least when it comes to macroeconomics, conventional wisdom no longer applies.

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NOTES

Aarati Krishnan. What the downgrade means for investors. The Hindu Business Line. August 6, 2011. Accessed August 6, 2011.
 Standard & Poors. United States of America Long-Term Rating Lowered To 'AA+' Due To Political Risks, Rising Debt Burden; Outlook Negative. August 5, 2011. Accessed August 6, 2011.
Niall Ferguson. A Greek crisis is coming to America. Financial Times. February 10, 2010. Accessed August 6, 2011.
The Economic Times. Market likely to swing wildly when trading resumes on Monday. August 6, 2011. Accessed August 6, 2011.
Lee Brodie. S&P Downgrade Could Bump Emerging Markets, Says Kelly. April 18, 2011. Accessed August 6, 2011.
Citigroup. Global Growth Generators: Moving beyond 'Emerging Markets' and 'BRIC'. March 1, 2011. Accessed August 6, 2011.
Ibid.
Greg Radford. Sustainable investing in emerging markets. International Finance Corporation. March 2009. Accessed August 6, 2011.
Ibid.
The Economist. Why the tail wags the dog. August 6, 2011. Accessed August 6, 2011.
Ibid., 1.

image: A family in Tarialan, Uvs Province, Mongolia, uses a solar panel to generate power for their ger, a traditional Mongolian tent, July 28, 2009. (credit: UN Photo/Eskinder Debebe, Flickr Creative Commons)

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