The Growth Map

There is still a great debate within the industry as to whether BRIC funds are anything more than a marketing theme. Some believe investors should stay well away from such theme-based approaches. In my new life as chairman of GSAM, I am learning that this is one of the great conceptual issues facing the asset management industry. Clients want good service, reliability and, of course, a good return. A theme-based investment fund might be a good way of raising assets, but it will not necessarily give clients the experience they want, and it depends heavily on the success of the investment manager. The BRICs, I believe, are different: strong enough as a theme to make a highly sensible investment strategy. As the BRIC economic story continues to unfold, then the specialist BRIC investment fund industry is likely to grow much more across every asset class.

The 2010 paper by Moe et al. explained the significant shifts we can expect to see just in global equity markets over the next two decades. Their work influenced me as I moved to my current role at GSAM and I tried to devise ways to explain and measure what is going on in the BRICs for our investors.

A vital part of this process is to build a useful benchmark. The problem when dealing with a phenomenon as new and potent as the BRICs is which benchmark to use. I began by considering the relative merits of market capitalization and GDP-weighted benchmarks. My first instinct was that market cap benchmarks gave too much weight to previous company performance, and failed to take into account the startling changes in the BRIC economies. Market cap benchmarks, I felt, led investors into already highly capitalized and fully valued stocks. But the more I thought about this, I realized that GDP benchmarking would go too far in the opposite direction. As I have already noted, many multinationals from the developed world have experienced rapid earnings growth from the BRICs and other emerging markets. A GDP-weighted benchmark would not acknowledge this fact, and would probably end up overweighting BRIC exposure. Anyone investing solely on the basis of GDP growth forecasts would have missed the phenomenal decades-long rise in Swiss equities.

A smarter approach, then, would be somehow to combine the two. Coincidentally, as I was trying to work all this out, Goldman’s quantitative research staff had been examining the volatility characteristics of investors’ portfolios. The global credit crisis of 2007–2008, the savage bear market in equities and the associated disruptions of many traditional investment beliefs compelled us to recognize that investors are much more interested in absolute returns than how their investments perform relative to a benchmark, as well as the volatility of a portfolio. In a collapsing market, comparing yourself to how others are doing—the essence of benchmarking—rather than concentrating on generating absolute, positive returns can quickly leave you hungry and broke. As I have become fond of saying, “Investors don’t eat relative returns, they eat absolute ones.”

The Holy Grail for me became an approach that combines minimum volatility, to reassure investors in difficult times, with exposure to the revenue growth of quoted companies from around the world, regardless of their domicile. If you can achieve this, you could have a portfolio that avoids the most highly rated and capitalized stocks while offering more exposure to the Growth Markets. Such an approach, applying a neutral weight to individual countries, would be very different from most current approaches, which benchmark against the country-weighted MSCI.

Getting the benchmark right is more than a purely technical issue. Even within Goldman Sachs I have colleagues who worry that by leading the push to change benchmark behavior, we could endanger our brand if the BRIC dream never materializes. I understand their caution, but we all have to move with the times to maintain a brand and show leadership. Only time will tell whether the approach I am proposing influences people.

Benchmarks are just one of many issues that we need to make sense of in the blizzard of conflicting information that emanates from the world of investing.

On a broad economic basis, I believe that—contrary to the pessimistic mood that engulfed the West after the credit crisis and again in the summer of 2011—the global economy is growing faster now than it ever has over the past thirty years. I try to show this for investors by focusing on the links between growth and asset returns. And I suggest that it is reflected in the equity risk premium (ERP), the extra return investors can expect on average for taking the risk of holding equities rather than so-called risk-free government bonds.

The trend of the world economy appears to be now growing a bit more than 4 percent a year, versus 3.7 percent over the past thirty years, because of the BRICs. If growth is a proxy for long-term earnings growth, then this means that company earnings around the world are rising faster than in the past. The ERP carries a lot of useful information for investing at any moment in time. When it is high compared to its own long-term history, it is likely to come back down in coming years. It can come back down through strong equity market performance and/or a rise in the risk-free rate (the yield on government bonds). When the ERP is low, as it was around the 2000–2002 period, investors are not adequately protected, and subsequently equities do poorly as the ERP rises. In addition to higher global earnings, the current ERP is high because of high dividend yields and, of course, rather low government bond yields.

The increase in the equity risk premium in recent years suggests to me that shares should rise in the coming years. It does not help to determine whether you should invest in Western companies with large BRIC exposure, such as Louis Vuitton or BMW, or directly in the BRICs themselves. For equity investors today, this is the hardest question.

In 2009, on the back of the global crisis, China expanded bank lending and credit considerably. This probably has involved some lending that won’t generate returns. I’m not blind to the fact that in the last decade the Chinese government had already had to deal with its worsening bad-loan problem by recapitalizing the banks using its foreign exchange reserves. It might have to do this again—after all, why hold such huge reserves if you aren’t going to use them for something? I am fully aware that the boom in China during these last ten years was helped by exports and massive growth in investment. This is highly unlikely to be repeated in the decade ahead and beyond. Indeed, it would be worrying if it were. China now needs to be led by consumption.

I find more reasons for optimism than pessimism about the commercial impact from China and the rest of the BRICs. When I talk to global companies, whether it’s Unilever, Nestlé or even my colleagues at Goldman Sachs, the excitement about the BRICs and the Growth Markets is palpable. When Kraft bought Cad-bury in 2010, the British press painted the acquisition as the loss of a British icon to an American giant. What that acquisition was really about was Cadbury’s business in India. The UK market was not at the forefront of Kraft’s thinking.

I’ve been talking to U.S. car companies for a very long time, and they have always been pretty suicidal about their industry. Not today. Since the whole BRIC theme started, they’ve become much more fun to spend time with. Growth has transformed their mood. It could even be said that these days General Motors is more a Chinese company than an American one.

There are some reasons to be cautious about investing in Chinese equities. Some of the publicly quoted companies might be companies without much quality and sustainably profitable business models. It can be dangerous for those eager to explore investors’ fascination with all things China. I can understand those who prefer to invest in China by working with privately owned partnerships run by people who thoroughly understand China’s domestic markets. I invest in some Chinese private businesses and in some private investment vehicles. Some public investments have also done rather well. Goldman Sachs’ earnings have been helped by our investment in the publicly listed ICBC bank in recent years. Some of my own personal Chinese investments have been among my more successful ones. The CEOs of big global companies want to be confident that they can get a good return on their investments and, when they want, are able to get their money out of China.

Not surprisingly, some Chinese find it odd and contradictory that Western businesses can criticize their public markets when the West has had its own financial crises and the United States has had to deal in particular with severe crises at, for example, Enron and Arthur Andersen as well as across the financial services industry. Russians hear us fretting about investing in some of their companies and say the same thing. Lots of BRIC policymakers don’t talk about a global credit crisis, but rather the North Atlantic credit crisis. What some of us see as natural investor anxiety, they see as prejudice. Beyond the usual justified paranoia of investing, at times it is tough not to have quite a bit of sympathy with their view.

When I listen to China’s leaders describe their ambitions, I start to think that the issues we see today are really just those of any markets that are emerging. We see the United States and the United Kingdom constantly revising and updating their financial regulatory systems. No market is ever perfect and so one must look to what each country aspires to. China, I believe, aspires to more open, transparent and liquid markets. It wants Shanghai to become a major world financial center, especially for equities. It wants Western companies to list stock there. HSBC bank is just one of the global companies to say that’s a very real possibility. This would allow global companies to tap fresh capital by letting 1.3 billion people add their stock to their investment portfolios. The only reason companies aren’t doing this already is because they are worried about the costs of doing so. What would it entail? What would be the regulatory consequences? What would be the impact on governance?

I would be staggered if by 2015 there weren’t several major Western companies with at least some equity listed in Shanghai. The Chinese want it and I’m sure the Western companies could use the capital. For China’s policymakers, the downside is that its equity markets could grow to the point where the slightest bump in them will panic global investors and make the economy more vulnerable to large capital outflows. The Chinese may become familiar with the expression “escalator up, elevator down.” Investors, whether domestic or foreign, arrive singly, but when things go wrong, they quickly depart en masse. This can create enormous volatility and instability, two things the Chinese fear especially. But they also know this might be a price worth paying as they want to advance and have more foreign expertise helping them develop.

The development of China’s markets in the coming years will be defined by the balance between two factors: the desire to open up and broaden these markets without allowing them to be capable of knocking China off its growth path.

The speed of local investment management development is also remarkable. As recently as 2007, when I went to Beijing to talk to Chinese investors I would primarily meet government officials, at the State Development Bank, the People’s Bank of China and SAFE, the State Administration of Foreign Exchange. These days, I meet private Chinese fund managers, and I talk with them as I would with hedge fund managers in London and New York. The speed at which they have learned, and the quality of their questions, is astounding.

There is no equivalent to the huge private Western fund managers yet in China, but they are emerging. Goldman Sachs has a good relationship with ICBC in China, and when I meet people in its distribution division, I am reminded of the similar investment giants from both the past and today in Japan. They built their business by going door-to-door to woo Japanese investors.

Many foreign companies find it more difficult to invest in India than in China. They see resistance from Indian policymakers and find it difficult to deal with the sheer number of people it takes to get beyond the system. For Indian policymakers, accepting a big foreign multinational can be a hard political sell. Indian politicians often seem to assume that any foreign investment will be interpreted as foreign exploitation. This can be very frustrating for international companies. India’s financial system could be a tremendous investment opportunity today, if only one could get access to it. Indian household credit is 8 percent of GDP, a sign of an economy functioning purely on cash. Any financial services firm that can help develop something closer to a Western retail banking system could probably make a lot of money as well as help India to transform. To get to where it could, India needs to outgrow some of these tendencies.

Ironically, and in contrast to many international companies, financial investors typically find India a lot easier to invest in than China, partly due to India’s colonial history and perhaps its English-based legal system.

Every country, BRIC or not, has its investment quirks. In Russia, the main concern is also often the government. I know people who have made enormous sums trading the most liquid Russian energy stocks, such as Gazprom. But anyone tending to invest in anything sensitive to those in the Kremlin, and who makes a lot of noise about it, risks trouble. That said, the Russians today are talking seriously about creating a special center for trading financial instruments in the ex-Soviet republics that make up the Commonwealth of Independent States.

Brazil is probably the easiest of the BRICs from an investing perspective. It is more Western and democratic than the others and has better-established domestic capital markets. Goldman has a thriving securities business there, with quite significant interest rate and currency markets. It is GSAM’s fifth most important market, and presently more developed than those in India and China. It is easily the most popular BRIC investment destination among private investors, including foreign and domestic private equity investors.

This means I worry a little. If everything seems so good, I like to worry. We all constantly have to weigh up risk, opportunity and what the consensus has already decided the value should be.

As I have mentioned, private equity is a very exciting area for BRIC investors. Part of the reason is the lack of free float in the market’s public equity markets, as well as the possibility of forging links with local experts and experienced native thinkers and businesspeople. Government entities still control large portions of public equity in the BRIC markets, either directly or indirectly, and place limits on foreign investors. Private equity offers a different range of opportunities. Shortly before the Blackstone Group—a leading investment and advisory firm—listed publicly in 2007, it sold 10 percent of its shares to China’s sovereign wealth fund, the CIC. It was a smart move by Blackstone for several reasons: not only did it give the company an important seal of official approval as it sought out investments in China, it also allowed the Chinese to invest money overseas through Blackstone funds without attracting the many raised eyebrows that often seem to accompany major sovereign wealth investments.

These days, many private equity firms are rightly looking at all kinds of opportunities in China, notably high-potential consumer plays. There are more and more Westerners who have set themselves up in China to do just this kind of investing.

Russia is a country where different firms take very distinct positions. Many, including some of the sharpest, toughest, best-connected private equity firms in the world, appear much less inclined to do business there. Yet others, such as the Texas Pacific Group, seem to have no psychological barriers to investing there. Interestingly, very recently a number of experienced global investors appear to have made a much bigger commitment to Russia and are committed to an exciting new fund, half of which will consist of Russian government capital.

As I have pointed out, India can sometimes feel like a prohibitive place for many investors, often offering tantalizing returns, yet frustrating prospects as it is difficult to get things done. Companies investing there can become entangled in bureaucracy, poorly drafted regulations and corruption cases. The Indian press and political class jump eagerly on even the slightest hint of corruption, especially when it involves foreign companies. Ambiguous tax laws for foreign investors exacerbate the challenge. In 2007, Vodafone acquired a stake in the Indian mobile operator Hutchison Essar, and has spent the years since battling through the courts over the taxes owed on the deal.

Opportunity has to be weighed against risk. Vodafone has also invested $23 billion in India in anticipation of a large, long-term opportunity. Big deals can get done in India, but it takes extraordinary patience. This explains partly why foreign direct investment in India has been weaker than in the other BRICs. The government makes it difficult even in areas where they, in theory, allow it. If India had a friendlier environment for foreign investors, foreign direct investment would grow sharply.

Over time, the development of local fixed-income markets in the BRICs will be even more exciting. Today the credit markets in China and India are in their infancy. Their bond markets are small, consumers save rather than borrow and companies depend on bank lending or informal cash transactions to fund their growth. Despite enormous infrastructure needs, the system of credit to fund roads, railways and airports remains primitive. On the demand side, investors are frustrated by the lack of investment opportunities. As the BRICs develop mutual funds and pension and insurance pools, there will be ever larger blocs of capital to be deployed. The history of economic development tells us that with economic growth comes the development of credit markets.

In the early 1970s the G7 bond markets were roughly similar to those of China today. What transformed them was financial deregulation, such as abolition of interest rate and foreign exchange controls, the liberalization of fees and commissions and finally demographics. As countries become more economically mature, their population ages, pension and life insurance markets develop, increasing the demand for bonds, and government lending rises due to lower tax revenues and greater provisions for health care and social security. Economic development consistently leads to a reduction in state ownership of corporations and control of the banking sector, which in turn leads to more evolved capital markets.

Between 1970 and 1995 the bond markets of Europe and Japan increased on average by the equivalent of 70 percent of GDP. Our analyses show that just over two-thirds of that growth can be attributed to the expansion in income per capita. The richer a country becomes, the more it borrows. At Goldman Sachs we believe that, by 2016, Chinese bond market capitalization could rise to around $4.5 trillion in today’s prices, about equal to the current size of the U.S. Treasury market or as much as the German and French bond markets combined. This process of debt market expansion is likely to occur in all the BRICs and Growth Markets.

It is worth looking even more closely at the capital markets in the two largest BRICs, China and India. In China, there is a wide gap between its economic growth and the maturing of its capital markets. The debt markets are still dominated by government debt, or securities issued by its “policy banks.” The fast-growing small and medium-sized enterprises have issued almost no debt, and have no bond market, despite comprising 60 percent of GDP and generating 50 percent of tax revenues. Instead, they must rely on retained earnings, bank loans and informal private financing, notably from Hong Kong and Taiwan. Greater access to formal debt markets would enable them to grow even faster. Their corporate bonds would also provide an excellent alternative investment for China’s savers, whose funds languish in low-yielding bank deposits.

There are many advantages to a country’s having a flourishing and vibrant debt market. It allows the more efficient allocation of resources across sectors and time. It means individuals and institutions can invest rather than save. And it will allow the financing and sustaining of China’s economic boom. If China continues to grow, as I believe it will, its debt markets will soon be an important part of the global economy.² The Chinese authorities still too often treat lending as an extension of government policy, allocating capital to achieve policy objectives in line with its priorities. The government has also made such extensive use of quantity and price controls to prevent economic overheating that it is tough for a market-oriented debt market to flourish.

The government’s attitude is understandably shaped by what occurred in the 1980s and early 1990s, when weak institutions and a poor understanding of market mechanisms led to the collapse of China’s fledgling corporate debt market. Today, we are seeing rapid changes, and it is likely that China’s debt capital markets will quickly catch up with the rest of its economic growth. In 2005 the People’s Bank of China established a commercial paper market to try to jump-start corporate debt borrowing, and while volumes are still light, it is gaining speed. The Chinese authorities are experimenting in Hong Kong with so-called Panda bonds, issued by foreign companies to raise money for investment back in China. As mentioned, McDonald’s was the first to issue a renminbi bond to fund its growth in China, and there have since been several others. China is not yet channeling its domestic savings into the capital markets, but as its pension, insurance and mutual fund infrastructure develops, that will have to change.

Many of the same points could be made about India.³ By 2016, the Indian debt market, public and nonpublic, could reach $1.5 trillion, two-thirds the size of Germany’s debt market today. Indian development has already led to lower inflation, improved public finances and higher foreign direct investment and foreign currency reserves. Collectively, these have reduced India’s vulnerability to shocks. But there remain serious concerns, notably the lack of transparency around its capital markets. So much Indian lending is done privately, which makes it next to impossible for public debt markets to develop. And yet the need for them is immense. More than any other BRIC, India is in dire need of developing its infrastructure. Indian corporate debt will be vital to this, and given its duration and link to inflation, such bonds would be attractive to pension funds and insurers the world over.

Like China, India needs to decouple its debt markets from its broader economic goals. It needs to stop ordering its institutional investors to hold lots of public sector securities, as this distorts the market for them. At the moment, India is caught in a familiar bind, known to economists as the “impossible trinity.” As it liberalizes the inflows and outflows of capital, it has to cede control of either its exchange rate or its monetary policy. If it tries to use interest rates to fix the value of its currency, in order to maintain its competitiveness, it risks capital pouring in and out to take advantage of the interest rate differential between India and its trading partners. If it tries to maintain the value of its currency by other means, such as buying it on the open market, it risks a liquidity crunch. On the other hand, if it tries to restrict the rise in the value of its currency by printing more money, it risks inflation. The only way out of the impossible trinity is to liberalize capital markets, so that over time interest rates converge with international rates, and there is less chance of being held hostage by foreign investors and their hot money.

There are also plenty of regulatory and technical changes India could usefully make. It could lower the high disclosure requirements it has for companies trying to issue bonds. Or reduce the high stamp duty rates on corporate debt. It could improve the legal framework for contract enforcement and lift the restrictions on foreign investors holding Indian corporate debt. It needs to encourage the emergence of market makers, develop better settlement and clearing systems and generally upgrade the environment for asset-backed securities. That way, its capital account can finally become convertible, thereby allowing India its proper place among the world’s economic giants.

While macro hedge fund investing involving the BRICs is pretty well developed, so-called long/short equity investing in the BRICs is relatively modest. The main problem is that the availability and diversity of stocks to short sell are much less than in developed markets. Therefore, such funds cannot act with the same speed and efficiency they can in Western markets. As yet, the BRIC equity markets are simply not big or liquid enough and the ability to short stocks much more difficult than in the more advanced markets. If you believe that Chinese banks are overvalued, for example, it is hard to find ways to short sell them on any scale.

It is also probably true that the regulatory systems are not as easy to deal with as they are in the West. That is changing, as investors find ways of coping with them and, more important, as BRIC markets develop and local regulators become more advanced, thus wanting to help develop their local markets. More hedge funds are opening and hiring in Hong Kong, Mumbai and Singapore. Brazil, again, may be the most advanced in this regard. Arminio Fraga, the Brazilian central bank chief who developed his country’s inflation-targeting policy, has had his own hedge fund for many years, which included both a long/short business and a private equity arm. In India there are a growing number of hedge funds run by Indians who have returned home after cutting their teeth in New York or London.

The world of BRIC investment, then, is becoming extremely varied, with myriad perspectives and opinions. I was recently in Tokyo, where I met the head of a major retail bank, Resona, who told me that he had guided 13 million retail customers in and out of trading the Brazilian real because of its yield. Historically there has been no more conservative investor in the world than the Japanese retail investor, so their decision to trade in Brazil’s currency is a great vote of confidence. At GSAM, we are now in the process of offering a Growth Market equity-based fund to be distributed by a third party in Japan.

Not far from my London office is the headquarters of Foster & Partners, the architectural practice responsible for some of the developing world’s most dramatic new airports and skyscrapers. I occasionally go to see them and we discuss their role at the center of BRIC urbanization. Until the global financial crisis, they were the biggest employers in the London borough of Wandsworth, and yet 85 percent of their business had nothing to do with the UK. This brings me to the final essential part of BRIC investing: developed-market companies that are profiting from BRIC growth.

I’m seeing this pattern more and more, of Western companies growing more quickly than ever, courtesy of the BRICs. If General Electric could get rid of its consumer financial arm and focus exclusively on manufacturing, heavy industry and infrastructure, it would probably be one of the best BRIC stocks in existence. General Motors, as I’ve noted, is as much a BRIC company as an American one these days. All the commodity companies are great BRIC investments.

I know some very smart people around the world who tell me that the best way to play the growth of China and India is to just trade the Australian dollar. I’m not sure I agree, but if you look back you can see how dramatically Australia’s trading relationships have changed. Australia used to be regarded as a good lead indicator of the economic fate of the United States. Not anymore. Its largest export partners, in order of size, are now China, Japan, South Korea, India and then the United States. These days, Australia is looking ever more to the rapid growth in Indonesia, which is just three hours away.

Australia will be in an incredible position for years to come, as it is rich in commodities and surrounded by fast-growing economies. The top end of the Sydney property market is already dominated by Chinese money, and I anticipate that becoming ever more true.

You could make a similar case for Canada and even Germany. I sometimes think of Germany as a fully developed way of investing in the BRIC theme. On my visits to Munich, when I go to companies like BMW and Siemens, I realize that China is more important to them than Germany or even Europe. Up in Hamburg, the once ailing port area has been completely regenerated thanks to trade with Asia.

Britain has aspirations to become a leading partner of the BRICs. One of David Cameron’s first overseas trips as prime minister was to Turkey, which he called the BRIC on our borders, and then onto India. London can often seem like the BRIC capital of the world. Its convenient time zone, the dramatic rise of the English language and the UK’s general open stance to foreign business and wealthy individuals has made London hugely attractive to many from the BRIC nations.

Britain is right to want to get more involved in BRIC growth, but its leaders have to do a better job understanding the BRICs and earning their trust. British service companies have great opportunities in the BRICs, in areas such as education, accounting and legal services. If Britain wants to succeed in creating stronger economic ties with these countries, its leaders will have to adjust their approach and not spend too much time trying to persuade them how to run their lives: accept them for what they are. For British companies to take advantage of new markets in the BRICs, their political leaders will have to be more thoughtful in their approaches.

The sheer range and number of global companies set to benefit from the growth in the BRICs prompted me and my old colleagues in investment research to create a developed BRIC Nifty Fifty index, through which investors can get BRIC exposure without having to invest directly in these markets. Since its inception a few years ago, this BRIC Nifty Fifty has strongly outperformed the MSCI Global index. We also created a separate Nifty Fifty for the BRIC countries themselves. By comparing the valuation of the two baskets at any moment in time, investors can choose whether it is more attractive to be involved in the developed-market companies with BRIC exposure or directly in the BRIC markets themselves. Not surprisingly, many investors watch the movements quite closely.

Of course, Goldman Sachs isn’t the only bank to have understood the staggering opportunity. Many other institutions and investors now grasp the potential in the BRIC economies. They realize what an important role the BRICs must play in our everyday business decision making. One cannot invest around the world these days and ignore or be frightened by the rise of the BRICs and the Growth Markets. It is much better to be open-minded. Despite the instability such changes bring, for millions of people around the world economic growth on this scale is a very positive story—and one that can be good for our investments.