Will the emerging market boom end in a bust – MoneyWeek

Butthistime,themanagercracks。

“Stop,stop”,hebegs,seeminglyonthevergeoftears。

“You’reright。

It’sinsane。

ButwhatcanIdo?

“IfIselltechanditgoesonforjustsixmonthsmore,allourinvestorswillpulltheirmoneyout。

We’llbebustandI’llbeunemployed。

Ican’ttaketherisk。



Thistalecropsupsooften,andisattributedtosomanydifferentpeopleandplaces,thatit’stemptingtoviewitasanurbanlegend。

Butinfact,Isuspectthatitsimplyhashappenedoverandoveragain,becauseit’sjustanextremeexampleoftheproblemwitheveryinvestment。

Icansympathisewithboththestrategistandthefundmanager。

There’satimetothinklikeeach–andthisisparticularlytrueifyou’reinvestinginemergingmarkets。

ReasonstoworryabouttheBRICs

Lastweek,ImetderivativesexpertSatyajitDastotalkabouthisnewbook:ExtremeMoney,whichI’llbereviewingsooninMoneyWeekmagazine。

Amongmanyothertopics,wetalkedaboutemergingmarkets。

Dasisfairlypessimisticontheoutlookfortheglobaleconomyaswetrytosortoutthelargestfinancialsectorcrisisinhistory。

Andheseesmuchtobeconcernedaboutinemergingmarkets。

Forexample,astheUSandEuropestagnate,Chinawillseealotofexportdemandfallaway。

Ifittriestocompensateforthisbycontinuallyincreasinginvestment,thereturnitgetsoneachroundofinvestmentwilldeclineeachtime(returnsonmanystate-directedinvestmentprojectsarealreadypoor)。

Atthesametime,thecountry’sdemographicsandthesystem’simplicitsocialcontract–thecommunistpartygetstoruleunchallenged,aslongasthepeoplegetwealthier–arguesfortheneedtokeepgrowthashighaspossiblenow。

That’sabigenoughheadacheforpolicymakers。

Ontopofthatyouhaveissuessuchasdealingwithtradetensions,andhandlingUS$2trnofcurrencyreservesthatareinasenseworthlessbecausetheycan’treallybesoldevenwhiletheUSdebasesthedollar。

Indiahastheoppositeproblem。

Itdoesn’tdependonexports,butinternationalfinancingandforeigndirectinvestmentisveryimportant。

Ifthisdriesup,anyonewhohasgotusedtoeasiercreditandabundantliquiditywillbeintrouble。

Meanwhile,thegovernmenthasn’tsucceededindevelopinginfrastructureandbuildingupthecountryinthewaythatChinahas。

Arguably,IndiamightactuallybeinaworsepositionthanChinatodealwithfuturecrises。

WhataboutRussia?

It’sessentiallyanoilcompany,dependentonhighdemandforcrude,drivenbyChinaandotheremergingmarkets。

Ifthatgoesaway,Russiadoesn’thavemuch。

Brazil?

Manypeoplewouldsaycommodities,butmuchofwhat’sbeendrivingtheBrazilianboomisasurgeindomesticcredit。

AsthechartbelowfromUBSshows,whilebankcredit(theblueline)doesn’tlooktoodramatic,onceyoufactorincorporatebondsandotherlending,Brazilhasseenasignificantriseindebtinthelastfewyears。

TherearemajorpotentialproblemsforsoutheastAsiaandelsewheretoo。

Butit’senoughjustbeawarethatthefourgiantsoftheemergingworldonwhomsomuchhopeisplacedarecertainlyasflawedasanyothereconomy。

They’rejustgrowingfasterandgrowthcanhideamultitudeofsins。

Everyboomturnstobust

EventhoughIwriteaboutinvestinginemergingmarkets,IagreewithDas’concernswholeheartedly。

Thereareplentyofrisks,imbalancesandstructuralproblemsineveryemergingeconomyIcanthinkof。

Andthenextdecadewillnotbekindtocountriesthatmakemistakes。

SoutheastAsiawasabletorecoverrelativelyquicklyfromthe1997-1998AsiancrisisbecauseexportdemandfromtheUSremainedrobust,andthecollapseoftheircurrencypegsmadethesecountriesverycompetitive。

Thesamesupportisnotavailabletoday。

Ofcourse,theredoesn’thavetobeacrisis。

Handledcorrectly,mostoftheserisksaremanageable。

Forexample,Chinacantrytodeployfutureinvestmentinawaythatdoesn’tproduceahighreturn,buthelpstoresolvesocialtensions(eg,byinvestinginhealth,ruraldevelopment,theenvironment,andimprovingtheruleoflaw)。

Thismightmeanthecountryfeelslesslikeaboomtown,butbecomesamorestableeconomy。

Aremoreoptimisticscenarioslikethisprobable?

Asageneralrule,Ihavelittlefaithintheabilityofgovernmentsandregulatorstoavoidcrises。

Afterall,theanswertoresolvingourcurrentproblemswasnottogetintothismessinthefirstplace–somethingthatwasatleastpartlyobvioustoanyonepayingattentionsincetheearly2000s。

SowhileIthinkthatbyluckordesign,someemergingmarketsmayavoidtheworst,Ihavelittledoubtthatmanyofthecurrentgrowthstorieswillendinacrisis。

Theinvestor’sdilemma

Thisisthestrategist’sproblemfromthestoryatthestart。

Ifhe’sofasufficientlybearishbentandisfamiliarwithhistory,heknowsthattheoddsarethatitwillnotendwell。

Butthemanagerdoesn’thavethesameluxury。

Theirquestionis:howsoonwillthebustcome?

Andthemanager’sproblemisclosertohowweactasinvestors。

We’renottalkingaboutthedotcomproblemofwhetheryoucanholdonforanotherquarterwhenthemarketisobviouslymad。

Bythen,youshouldbebailingout。

Instead,let’sconsidertheUSatthestartofthe1990s。

Thepessimistcouldhavepointedtodebtlevels,whichhadexplodedoverthepastdecade,fromaround150%ofGDPtoaround250%ofGDP。

Therewasnowaythiscouldcontinueindefinitely。

Meanwhile,thestockmarketlookedfairlyvaluedandperhapsevenabitexpensiveonlong-runmeasuressuchas‘equityq’andthecyclicallyadjustedcyclically-adjustedp/e(CAPE)ratio。

Thiswasclearlynotagreattimetobeinstocks。

Ofcourse,overthenexttwodecades,thedebtproblemcontinuedtogrow,hittingaround350%ofGDPbeforeeverythingcametumblingdown。

Stockshadanup-and-downridethroughthedotcombubble。

ButtheSPwentfromaround400intheearly1990stoover1,500atthepeakin2008。

Andyoudidn’tneedtoparticipateinthedotcominsanitytoderivesomebenefitfromthatbullmarket。

Buyingsomethingas‘boring’asColgatePalmolivewouldstillhaveproducedverygoodreturns。

SoI’dapplaudthestrategistforspottingtherisksearly。

ButIwouldnotbehappywithaninvestmentmanagerwhohadkeptmeincashandfailedtorealiseanygainsfromthemarketover20years,basedonthatsamestrategy。

Everymajorbullmarketendsinabubbleandthenabust。

Successfulinvestingisn’tjustaboutspottingthebubble。

Ithastoincludeworkingouthowmuchyouwanttoparticipateinthatbubbleandhowyouwillavoidtheworstofthebust。

Buythevalue,sellthebubble

Now,veryobviouslythisisnotthesameenvironmentasthe1990s。

Thenextfewyearsaregoingtobeverydifficult。

Volatilitywillbehighandcriseswillescalateeasily。

Nonetheless,manyemergingmarketsaredoingwellandshouldcontinuetodoso,evenifgrowthisslowerthisyear。

Andwithgrowthandoptimismsettobescarceintheyearsahead,countriesthatofferitwillbeseenasattractiveinvestments。

Thismaywellendbadly。

Indeed,themoreforeignmoneyrushesintoemergingmarkets,themorelikelyanastyoutcomewillbe。

Butwhetherthathappensintwoyears,fiveyears?

tenyearsornotatallisimpossibletosay–onlythatpresentvaluationsdon’tsuggestwe’reinabubble,asI’venotedalready。

Andthereareonlyafewcases–suchasTurkey–wherethereareobviousimmediatemacroeconomicrisksthatdon’tyetseemtobereflectedinprices。

Vietnam,forexample,isstillstrugglingwithinflationandoverheating–butlooksverycheap。

Sowhatdoyoudotogetsomebenefitfromthis,whilenotbeingrecklessabouttheveryrealrisks?

Thefirstthingistobediversified。

Obviously,emergingmarketsshouldnotbetheonlythinginyourportfolio。

Buybetterqualityfirms,ratherthansecond-ratepeers,eveniftheylookmoreexpensive。

Higherqualitystocksperformwelloverthelongrun,whilehavingbettersurvivalprospectswhenitallgoeswrong。

Youmightstillchoosetosellthemwhenyouthinkacrisisisimminent–butyouprobablydon’tneedtoworryaboutthemgoingbust。

Takealong-termview。

Ifyoubuyhighqualityinvestmentsandyouhaveaten-yearhorizon,thenacrisisthatlastsevenacoupleofyearsismuchlessofaconcern。

Holdsomecashandnear-cash(shorter-termliquidbonds)。

Yieldsarelow,butitgivesyouoptions。

Youdon’thavetobeaforcedselleratthewrongtimeduringasell-off。

Andyouhavefundstoinvestwhenacrisishits,whichiswhentheopportunitiesarebest。

Finally,youneedtobalanceyourinnerstrategistwithyourinnermanager。

Andtheonlywaytodothisisbyinvestingwherejustifiedbyvalueandhopingthatitturnsintoabubble。

Don’tinvestintoabubbleinthehopethatitwillbecomeabiggerbubble。

That’sthedifferencebetweenbuyingtheSPinMarch1990andMarch2000。

Theformerwasthetimetotrustthemanager,thelatterthetimetotrustthestrategist。

It’seasiersaidthandone–butit’swhateveryemergingmarketinvestorneedstobearinmindduringthemuchtougherdecadesweface。

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