By Marshall Stocker
One of the core tenets of our emerging market investment philosophy is that growth of economic freedom is a strong driver of excess returns, in both equity and debt markets.
This was true in the examples of Poland beginning in 1990 and Romania of the 2000s, and is supported by the research of Eaton Vance and others. But confirmation of this principle is always gratifying, as we have seen most recently with Georgia – a country we have been bullish on for several years.
On September 15, the Fraser Institute released its annual report Economic Freedom of the World, in which Georgia moves up to number five from number 12 in the economic freedom ranking of 159 countries. Moreover, 2016 is not an anomaly – Georgia has been moving up steadily from number 75 in 2004.
Fraser scored Georgia highest on freedom to trade, and it is not hard to see why. Russia cut off its huge trade volume with the country prior to their five-day war in 2008, and Georgia found other trading partners. As we noted in July, Georgia’s industriousness has paid off with GDP growth that has averaged 5% per year since 2010.
Georgia is a small country, and hardly likely to move the needle on an emerging market portfolio. But our research has shown that the relationship between improving economic freedom and equity investment results has persisted for decades over a broad range of countries. The results were similar in fixed-income markets, as increasing economic freedom corresponded to lower yields on sovereign debt.
Specific to Georgia, the country’s 10-year Eurobond issued in 2011 has become more valuable as its spread to an equivalent U.S. Treasury has contracted by nearly 100 basis points (bps), compared with a 60-bps higher yield on the JP Morgan Emerging Market Bond index.
We believe that when the factors that comprise economic freedom are considered, it is fairly self-evident why their growth helps drive equity returns and reduce bond yields. For example:
Size of government—As governments become smaller, in terms of share of total consumption and investment, companies face decreasing competition for investment capital and market share. This reduces corporate financing and operating expenses while increasing revenues and expected cash flows. Reducing government size has been favorable for equity and debt prices.
Legal structure and security of property rights—Changes that make property rights more secure and give equity holders better protection against fraud and nationalization reduce uncertainty and decrease the discount rate. Such changes have increased equity valuations and reduced bond yields.
Access to sound money — When a country’s inflation rate becomes more stable, it is a plus for the economy because it lowers uncertainty for investors. This has led to a reduction in the discount rate, greater equity valuations and lower bond yields.
Freedom to trade internationally—Trade liberalization increases a company’s ability to pursue international markets and has increased expected cash flow and equity values.
Regulation of credit, labor, and business—Changes that reduce government mandates and regulations lower transaction costs, have increased cash flows, boosted equity values and reduced yields.
Bottom line: Emerging markets have, on average, a lower level of economic freedom. Thus, small changes in economic policy can represent a large percentage change in level of economic freedom – and the potential for corresponding gains in their equity and debt. Georgia is just the most recent case in point.
Marshall Stocker is global macro equity strategist & portfolio manager at Eaton Vance.
