By Jonas Wäingelin, NordicInvestor

Two recent papers from Wellington Management’s Investment Strategy Group (Structural change in EM… and The future of EM…) examined the opportunity related to economic development in emerging markets (EMs). In this Q & A, Portfolio Manager Dáire Dunne, CFA, outlines his thoughts on the importance of this secular trend and the investment opportunities it is creating.

Q. How does economic development differ from economic growth?

A: Economic growth is about increases in gross domestic product, which is a quantitative measure of the size of an economy. It measures the quantity of economic change over time.

Economic development is concerned with the quality and durability of this change. It relates to increasing the productive capacity of an economy, making responsible use of available resources, promoting economic inclusivity, and engendering a better quality of life for citizens. Development puts in place the foundations on which long-term, high-quality economic progress can be achieved.

Q. Why does economic development matter?

A: Our research shows that economic development is consistently associated with more stable economic progress and inflation paths across countries and over time. The importance of macro stability in EMs cannot be overstated. Those countries with the highest level of macro stability generally have easier and cheaper access to international capital markets — an enormous advantage when making long-term, productivity-enhancing investment decisions. An additional consequence of development progress is political stability. Governments that improve the social, economic, and environmental contract they have with their citizens tend also to command more enduring popular support and build clear political legitimacy.

Q. Does economic development impact financial markets?

A: We see clear linkages between development and financial markets. Development helps establish positive feedback loops between the public and private sectors, fostering political transparency and stability, as well as entrepreneurship. These are all essential ingredients for long-term economic progress. Markets, as well as credit agencies and lenders, consider these variables in their assessment of risk premia.

There is also evidence that countries with an economic development focus are more likely to enter self-perpetuating cycles of productivity and innovation. In addition to generating lasting improvements in living standards and social mobility, this economic development focus creates attractive opportunities for investors related to local policy and domestic demand. Our research highlights the fact that those parts of the emerging world that have made the most development progress also have established the broadest and most liquid equity markets and most profitable corporates, as measured by average returns on equity.

Q. Where do you believe economic development is most visible in EMs today?

A: Across Asia, there now is widespread commitment to infrastructure investment, from the Build, Build, Build program in the Philippines, to improvements in inter-island connectivity in Indonesia, to the Eastern and Western Dedicated Freight Corridors in India.

Recent Chinese five-year plans feature an increased focus on education, for example, in the world-class universities scheme, and on health care, as with the Health Action Plan, which aims to provide universal health care by 2020.

India’s academies for the poor, China’s education startups, Indonesia’s empowering credit entities, and Kenya’s mobile payments advances also speak to the educational and financial aspirations of many across EMs.

Q. What are the benefits of using a development lens in EM investing?

A: Investments that either enable or benefit from economic development are disproportionately local in orientation, idiosyncratic in their risk profile, and capable of generating high earnings growth over time. These characteristics are very attractive when considered in a portfolio context. It is also worth noting that these investments features are in contrast to a large part of the traditional quoted markets in EM (or passive benchmarks), which tend to be cyclically sensitive and highly correlated with developed markets.

Q. Are economic development and sustainability investing related?

A: The positive social, economic, and environmental aspirations of economic development and sustainable investing (SI) are very well aligned. While development focuses on evolutions in economic structure, SI is more concerned with the positive role that financial market participants can play in this evolution. In our view, they also share similar long-term objectives: namely, a better, cleaner, more productive and more inclusive future. In 2015, the United Nations outlined 17 Sustainable Development Goals, which focus on ending poverty, fighting inequality, and stopping climate change. Investing with a development focus means identifying companies that are helping to facilitate these outcomes.