Emerging or submerging – the investment consequences of the Greek downgrade

20th June 2013


Some would say it had been coming for a while, but the MSCI has finally downgraded Greece to emerging market status. The problem for investors is that Greece is probably not the sort of exciting, high growth market that they were after when they decided to invest in emerging markets. Do investors need to revisit their view of emerging markets in light of a new breed of ‘submerging’ markets asks investment journalist Cherry Reynard.

The downgrade by no means suggests that Greece has bottomed out. The IMF still puts Greece top of its ‘ Inflation vulnerability index‘. To put this in context, it is the only major market considered high risk; Spain and Ireland are considered to be medium risk and in both cases, that risk is decreasing. Greece, in contrast, continues to become more vulnerable to deflationary pressures.

Real GDP dipped by 6.4% in 2012. It is due to fall by a further 4.2% in 2013 and then finally return to anaemic growth – 0.6% – in 2014. The current account deficit was still 2.9% of GDP in 2012 and is not predicted to return to surplus until 2014. In the meantime, unemployment is currently an eye-watering 27% and is only expected to fall marginally when/if the country returns to growth in 2014.

Erin McCarthy and Prabha Natarajan, writing in Wall Street Journal blog, highlights the dilemma for investors.

“Countries deemed to be emerging markets by Bank of America-Merrill Lynch are expected to grow an average of 4.9% this year, according to the bank’s analyst. In contract, the International Monetary Fund predicts Greece’s economy will contract by 4.2%.

“Last year, developing countries had debt levels that averaged about 35% of gross domestic product, according to the IMF. Greece’s debt-to-GDP level was 159%.”

The article quotes Brian Jacobsen, chief portfolio strategist for Wells Fargo Funds Management, saying: “You don’t think of a submerging market like Greece when you think of emerging markets. Greece is a bit of a sore thumb that will stick out in the index.”

There is some debate as to how much passive money will shift in and out of Greek markets as a result of the change in status. On CNBC’s trader talk Bob Pisani points out that the Greek stock market was down 1.7 percent in the day after the downgrade, the worst performer in Europe: “This is not just a casual moves: the MSCI indices are tracked by $7 trillion worldwide. It means some who are indexed to the funds will remove Greek stocks.”

However, the Financial Times (behind paywall) reports HSBC estimates that Greece will lose $194m from developed market investors on its exit from the indices in November, but gain just over $1bn in emerging market money.

The inclusion of Greece in the indices is likely to be more of a problem for investors choosing a passive or strictly benchmarked strategy. An active manager can choose to leave Greece out of their investment remit and focus on higher growth regions. For the rest, who are now forced to have an exposure to Greece, emerging markets become less a growth investment and more of a recovery investment. This has its merits, but it might not be what was originally intended.

That said, it could be argued that emerging markets in general are perhaps not the growth play they once were. Maarten-Jan Bakkum, Senior Emerging Markets Strategist at ING Investment Management says in a recent note: “Emerging markets have had a rough time recently. Over the past two and a half years, their economic performance has stayed behind that of developed markets. The debt crisis has led to meaningful change in the US and Europe. In the US, the banking system has been cleaned up and the economy appears to be moving again…. The emerging world looks a bit pale by comparison. The source of the debt crisis obviously lay in the developed markets, and the urgency of reform was simply greater in the US and Europe. Still, it is disappointing to see how little economic reform has taken place in the emerging world in these past years.

“(Emerging markets’) competitive strength has weakened, and their economic instability has grown…Substantial job market reform, less government intervention in the economy, a better investment climate and more room for infrastructural investments in government budgets would have a positive impact on potential growth in emerging markets. But except for Mexico and India, we see little initiative in this direction.”

Equally there are those who argue that Greece is not quite the basket case it once was. Ian Stewart, chief economist at Deloitte, points out that the possibility of Greece exiting the euro zone has receded “markedly”, due to the improved stability of Greece’s coalition government and an upgrade in growth expectations in the euro area. Greek business sentiment hit a three and a half year high last month.

So it may be that ultimately Greece and its new emerging market peers will meet somewhere in the middle. Either way, Greece’s downgrade represents a change in the nature of an emerging market investment to which investors should be alert.

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