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Are Emerging Markets Free of US Credit Crunch?


The additional risks of emerging market investments are also not being properly priced.

2007 is increasingly regarded as the year in which the credit crunch commenced, and it also marked the start of a fundamental shift in the balance of the global economy in favor of emerging markets. Advisors are quick to invent "new" themes to "help" investors struggling with the perennial question of where they should invest. Unfortunately, investment ideas can often be narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts.

The events of 2007 did not directly touch everybody. Problems in capital markets were fairly remote. What on earth were these things with colorful acronyms – CDOs (Collateralized Debt Obligations), ABS CP (Asset Backed Security Commercial Paper) conduits, SIVs (Structured Investment Vehicles) – anyway? Was "AAA" the cup size of an undergarment or a statement of investment quality?

For more on these topics, see Investment Theme du Jour and Investors Go for Mo? both by Professor Das.

Immediate evidence available to investors did not accord with the abundant gloom and doom. "Sub-prime" was a problem of poor and greedy borrowers who had gotten in over their head and avaricious bankers, complicit in the sub-prime mess were getting their comeuppance. It certainly did not affect many people directly, although it did dominate the news and make the stock market behave like Elvis' pelvis in a 1950s film clip. Foreclosures and delinquencies were generally confined to a few communities. Even in the global village, human beings rarely think of anything as real until it happens to them directly.

2008 has already brought a realization that "things are rotten in the state of Denmark". Equity markets are off and the threat of recession is more real.

For the last 15-20 years, developed economies have enjoyed a period of rising wealth, improving living standards and relative stability. Economic corrections have been comparatively mild and short-lived. This period was underwritten by three factors – low inflation, rapid growth in global trade and a remarkable growth in the availability of cheap debt (disguised as financial innovation).

The sub-prime problems have radically and abruptly reduced the supply of debt. As I have written previously, the credit crunch has some way to run. As the oxygen of cheap and abundant debt is withdrawn, a key pillar of support for the economy and equity market disappears.

Prosperity globally has been supported by U.S. consumption, much of it debt funded. U.S. wages have barely increased in real terms in 30 years as a result of global competition in traditional industries such as manufacturing. Rising house prices were converted into cash through home equity loans. At the height of the boom, around $1 trillion in home equity was generated via re-financing of existing mortgages and second mortgages fueling consumption.

In past crises, consumption remained remarkably resilient. This time falling U.S. house prices and the credit crunch will affect the ability of U.S. consumers to borrow, slowing consumption. If the economy slows, a fall in equity markets and higher unemployment levels will also restrict U.S. consumption. Higher inflation (especially fuel and food prices) is also limiting non-essential discretionary spending.

U.S. corporate profitability has started to fall from the cyclical peak. Slowing consumption and lower economic growth will exacerbate the slowdown. Financial services, housing, automobiles, retailers and consumer durables look vulnerable. A lower dollar and strong export growth has helped cushion the decline somewhat. Exports are around 10-12% of the U.S. economy so cannot take up the entire slack. Lower corporate earnings feed back into equity prices that feed back into consumption that feed back into corporate earnings – "so it goes".

In the past, the committee to save the world combined with interest rate cuts managed to save the day. Lower rates set off asset price bubbles that were monetized via cheap debt to support further consumption. This time interest rate cuts are unlikely to have the same effect. Excessive borrowing levels limit the scope for the consumer to borrow and spend their way out of the problems. Asset prices - especially house prices - are also falling, lowering the ability to create debt.

As I have argued, the rates cuts will merely smooth the adjustment process and support the fragile banking system. If the lower rates create higher inflationary expectations then long-term bond yields may rise further accelerating the slowdown. James Carville, political advisor to President Bill Clinton, awed by the power of the markets once remarked that: "he wanted to come back as the bond market".

Investors are now looking to the emerging markets of Asia, Eastern Europe and the Middle East for returns. In the first weeks of 2008, Russian equity markets gained 1.0% (1 year +28.5%), India's Sensex index rose 0.7% (1 year +53%) and China's Shanghai Exchange gained 2.3% (1 year +98%). In contrast, the U.S., European and Japanese markets fell around 4-5% during the first weeks on 2008.

Emerging markets are being driven by substantial short-term capital flows fleeing developed markets and the U.S. dollar. In the U.S. presidential election campaign, the key electoral USP ("unique selling proposition") for Democrat and Republican candidates alike is that there are not George Dubya. Currently, the investment case for emerging markets is primarily that they are not the USA.

The Indian and Chinese stock markets are trompe-l'oeils - paintings designed to deceive the eye. They may provide a dangerous illusion of a modern economy for foreign investors.

While emerging market economies are likely to grow at a higher rate than developed countries, equity valuations and earning growth may not be sustainable. Earnings quality is variable and growth has increasingly been driven by investment income – stock market, currency and property speculation. Investment returns in many case are below the cost of capital and projects are predicated on high, continued economic growth well into the future.

Share prices are prone to being influenced by insiders and their associates. In the case of China, most traded shares are in government enterprises that continue to be controlled by the State. Some Chinese shares aren't even really shares as they don't convey full ownership rights equally to all shareholders.

The Indian and Chinese markets have been driven by a number of initial public offerings generously priced to provide investors (themselves privileged insiders) with large gains. A few shares contribute disproportionately to market performance. A handful of stocks drove the rise in India's Sensex Index in late 2007 reflecting the lack of liquidity in many stocks. In China, restrictions on foreign investments by domestic investors and the lack of investment alternatives has contributed to the sharp increase in the price of Chinese stocks. Borrowings by corporations and individual investors have been channeled into the stock market creating dangerous levels of leveraged exposure to share prices.

De-coupling assumes that emerging markets will not be significantly affected by a U.S. slowdown. Exports account are significant for most emerging market economies. Russian and Brazilian growth depends on commodity demand and high commodity prices. A slowdown in the U.S. and Europe will affect growth.

The belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested. The Indian, Chinese and Russian economies may be capable of becoming self sustaining growth engines but only in the longer term. Their ability to take over from the U.S. as the driver of the global economy in the short run is questionable – after all the Euro zone and Japan have never successfully fulfilled this role.

India and China face infrastructure constraints that will constrain growth. Inflation (higher energy and commodity costs and rising domestic costs) and rising local currency interest rates may slow growth. Both the Indian rupee and Chinese Yuan has appreciated against the U.S.dollar. Currency appreciation attracts capital flows but reduces local currency earnings and the competitive position of exporters .

Corporate earnings growth in developed countries assumes an increased contribution from sales to rapidly growing emerging markets. Commodity prices and the fortunes of commodity producers are underpinned by the emerging market growth story. A U.S. slowdown will lead to a slowdown in emerging markets which will lead to slowdown in the U.S. - "so it goes".

Some emerging markets are also dependent upon foreign capital. For example, India is running a trade deficit of around 10% of GDP and a budget deficit of around 3%. This must be financed. To date, this has been financed, in part, by foreign capital – both portfolio investments and foreign direct investment. Changes in global financing conditions may adversely affect India and its growth prospects.

The additional risks of emerging market investments are also not being properly priced. Enforceability of property rights, good corporate governance, equal access to timely, accurate financial information, corruption and political risks are being ignored.

The sheer complexity of the global economy and the supporting financial system makes it impossible to know how this will play out. The dynamics of the interplay between global financial markets and the world's economies may be in the process of fundamental change. Getting on the right side of these changes will shape investment success or failure in the coming years.

Investors need to be prepared for these changes and have the capital to take advantage of these opportunities. Thomas Edison once remarked: "There's value in disaster. All our mistakes are burned up. Thank God, we can start anew." That wisdom may be more applicable than ever in 2008.
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