Stop worrying and love emerging markets

April 27, 2010

Better growth, less debt and what is shaping up to be a very nice little supply and demand mismatch make emerging markets very attractive relative to the developed world.

Sure, China could go ‘pffft’ every now and then, and yes, there is potential for getting caught at some point on the wrong side of a deflating bubble, but boom and bust is the world in which we live. Stay in the developed world and you could get run over by the proverbial Greek bus on its way out of the euro or see your portfolio shot out from under you by the bond market vigilantes.

And, as the International Monetary Fund pointed out last week, emerging market returns have been better on a volatility adjusted basis, both during the downturn and the market recovery. Think about that: historically the trade-off in emerging markets has been that you try to capture a share of superior economic growth but bear the risks of higher volatility and a bigger chance of being abused as an investor by entrenched local interests.

Well, the volatility/reward equation is now apparently better in emerging markets and, last time I checked, it was U.S. subprime mortgages not Indonesian corporate bonds that formed the underlying collateral on which Goldman Sachs’s famous Abacus deal was based.

Even some valuation statistics can be marshaled in support of emerging markets. Shares in China and Brazil are, by some measures, selling on lower multiples of expected 2010 earnings than the U.S., for pity’s sake. Vaunted value investor Jeremy Grantham, of GMO, is overweight emerging markets, though he seems almost sheepish:

“Within my personal portfolio, I have a stronger preference for the already overpriced emerging market equities than do my colleagues at GMO, and actually more than I should have as a dedicated value manager … The appeal of emerging’s higher GDP growth compared with the slow growth of … developed countries is proving as compelling as I suspected, and I would hate to miss some modest participation in my one and only bubble prediction,” Grantham wrote in a letter to shareholders.

Less debt, particularly less government debt, is a key advantage for emerging markets in coming months and years. While gross government debt as a percentage of GDP will breach 100 percent among industrialized countries in the G20 between now and 2014, for their emerging market counterparts the trend is downward. That is important for two reasons. First, it means emerging markets don’t face the risk of a sovereign debt crisis to the same degree, and secondly, if the recovery falters, as well it may, they have more headroom for stimulative spending.


So, the fundamentals are pretty strong, but anyone who has been both alive and awake this last decade will realize that good fundamentals and four bucks will get you a cup of coffee at Starbucks. What emerging markets have going for them are a reasonable expectation of strong investment flows combined with a thin supply of investable assets.

Flows of portfolio investment from developed to emerging markets are already strong, and for a pension fund manager sitting in California or Iowa the temptation to go increasingly overweight into emerging markets will be strong. It will be hard to continually make 8 percent in a 2 percent GDP growth world and with many state, local and company pension plans facing huge deficits, swinging for the fences by plunging into  emerging markets is likely to become more common.

Combine this structural flow with a structural capacity problem and prices could move sharply. Whereas British shares equal about 115 percent of GDP and U.S. ones a little over 80 percent, there simply aren’t that many assets one can easily buy in emerging markets. In the broadest MSCI equity index Chinese shares only equal 14 percent of Chinese GDP, with Russia and Indonesia just 12 percent. Now don’t you worry, come the bubble, China and the others will make more assets you can easily buy, but it could be a scary fun ride on the way up.

Then finally, there is the issue of where the great flood of bank money goes when finally it leaves the house.

For Ben Bernanke the key question is when he hits the brakes in response to banks starting to put money back to work rather than parking it with the Federal Reserve. Continued high unemployment and sluggish growth will make it tough for the Fed to pull the trigger soon, and, there is always the possibility that the money gets put back to work not in the United States where it would directly lead to U.S. inflation, but elsewhere, such as in emerging markets. Mr. Fire meet Ms. Gasoline.

All cross-border asset bubbles are different but they are all the same in one respect: they have a good story. This may be one of the best.


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