Kotak Institutional ‘Cautiously Optimistic’ on Emerging Markets

Kotak Institutional Equities has laid out a cautiously optimistic view on emerging market (EM) equities in its latest strategy report, arguing that select countries could benefit from favorable demographics and improving economic fundamentals. However, EMs will need to manage risks from democracy and disruption to realize their long-term potential.

India will hold a pivotal position among emerging markets given its vast growth possibilities and increasing weight in equity indices. But EMs can ill-afford policy missteps as witnessed over 2011-13 in economies like Russia and South Africa after initial promise, Kotak Institutional Equities said.

In the report titled ‘EMs at Crossroads’, Kotak notes that major EMs like Brazil, India, Indonesia, Mexico and Vietnam are poised to increase their share of the global working-age population as populations age rapidly in developed markets (DMs) and even China. These countries could provide the workforce to offset labor shortages in DMs.

India will account for a massive 26% of the world’s growth in working-age population from 2023-33. Its demographics will remain supportive till at least the 2050s. Other EMs like Brazil, Indonesia, Mexico and Vietnam will also see steady if less spectacular increase in working-age population over the next 20-30 years.

Healthier Fundamentals

The report highlights that EMs have better macroeconomic fundamentals currently versus DMs, an advantage they did not enjoy in the past. Emerging economies have reduced government debt ratios in recent years and run smaller fiscal deficits, aided by restrained pandemic stimulus compared to massive spending by developed nations.

EM central banks have also been more proactive than DM peers in hiking interest rates to combat inflationary pressures. As a result, price rise remains more under control in key EMs like India, Indonesia and Brazil compared to near double-digit inflation in the US and Europe.

Kotak expects growth rates to remain higher in emerging countries as lackluster demographics crimp demand in much of the developed world. India and Vietnam are forecast to deliver GDP growth of 6-7% over the medium-term.

Geopolitics to Aid External Balances

Many EMs like India, Mexico and Vietnam could see their current account positions strengthen due to global supply chain shifts induced by geopolitical realignments, the report said. These countries are gaining as high-cost China cedes market share across various industries.

India is attracting new investments under the production-linked incentive scheme across sectors like electronics, solar modules and batteries. Mexico and Vietnam are leveraging their geographic proximity to the US and low-cost advantage respectively.

Lower Cost of Equity

The research report believes that sustained high growth could gradually lower the cost of equity for select emerging economies as their credit profiles improve.

However, the journey to structurally lower bond yields and equity risk premia will likely be slow and take decades. As per Kotak’s analysis, countries like Germany, Japan and South Korea saw meaningful declines in cost of capital only after reaching high per capita income levels of $20,000+ over 1990-2000.

Key emerging markets are currently at much lower per capita income levels. But India, Brazil, Indonesia and Mexico have exhibited prudent fiscal policies so far, which bodes well for macro stability over the long run.

Risk Factors

While sounding optimistic on the potential, Kotak cautions that EMs will need to manage two key risks on their path to developed nation status:

Democracy – EMs like India, Brazil, Mexico and Indonesia have established democracies which bring political stability. However, institutions remain fragile and will require constant strengthening.

Disruption – EMs must adopt new technologies rapidly to overcome historical disadvantages versus DMs. They also need to cope with disruption to sectors and business models to protect growth and profitability.