It’s a generalization, but I’ve noted that the more experienced and sophisticated investors are, the more likely they are to have an allocation to emerging markets(1) and the more likely they are to be overweight in EM. I know otherwise sane and intelligent people who have extreme over-allocations to EM (double the cap-weighted exposure, for example).
On the other hand, users of the Moneybags© mobile financial app(2) will be aware that the Moneybags sample portfolio has a slight underweight position in EM, a tactical view that has paid off over the past six months. Moneybags and the Man-Behind-the-Curtain (your humble correspondent) have been skeptical about EM recently. More important, I’m also a bit skeptical about the prospects for EM longer term. Here’s what’s been going through my mind.
Stepping back a few years, we observe that once Communism went to its well-deserved grave the developing economies of the world finally had a chance to, well, develop. Which many of them have done, with a vengeance. Even China, until thirty years ago a hard-line Maoist state, adopted a capitalist economic model. It took about a decade for the formerly non-capitalist societies to get their acts together, and during that decade we were treated to, for example, the Mexican peso crisis (1994) and the Asian financial crisis (1997).
But then the BRICs were invented(3) and EM took off, chalking up returns of nearly 11% per annum over the past ten years, versus less than 5% for developed country equities.
The question, though, isn’t what EM did in the past, but what it’s likely to do in the future. And here I fear that dark clouds may be gathering. I’ll explain my misgivings in a four-part post, this being the first.
The main reason investors allocate to EM stocks is their view that the developing countries will grow much faster than the developed countries, and therefore EM will produce higher returns.(4) To pinpoint the fallacy in this view, it’s useful to analogize EM countries to “growth” stocks. Like growth stocks, EM countries are rapidly growing, exciting, sexy. They seem to belong to the future, whereas developed countries and “value” stocks seem to belong to the past.
But as we all know, value stocks have beaten growth stocks fairly substantially over time, and it may well be the case that value countries (the developed world) will beat growth countries (the emerging world) in the future, especially on a risk-adjusted basis. Here’s why this could happen:
* First, everyone on the planet knows that the emerging economies are growing faster than the developed world, that their stock exchanges are generally fairer than they have been in the past, and that the emerging countries have broadly managed their economies well in recent years (albeit largely by accident). And so guess what? The good news is already priced into the emerging markets – you can only make money on a risk-adjusted basis if those markets do even better than everybody thinks they will do. This seems unlikely.
* Second, there is no necessary correlation between a region’s rate of economic growth and the investment returns of investors in the region, any more than there is between rapidly growing companies and their returns. Price is everything. Consider that in the United States – once the greatest “emerging market” in the world – economic growth was much stronger in the 19th century than in the 20th century, but returns were about the same. Or look at Asia versus Latin America in the first decade of the 21st century: Asia experienced much faster growth, but Latin American returns were three times as high. But the real poster child for the perils of the economic growth story is China: although China’s GDP has risen roughly 7X over the past 20 years, versus roughly 2X for the US, the Chinese stock market has dramatically underperformed the US market.
* Third, note that there is a technical problem with emerging market stocks, as with growth companies generally. Companies in emerging economies are growing rapidly, and, to fund that growth, they issue stock financings that invariably dilute existing shareholders – who are thereby “cheated” out of the returns they might have expected.
* Fourth, rapidly growing growth companies – and especially their madcap cousins, tech stocks – tend to be victimized by “hot money,” investors who like to jump on trendy trades and then jump off at the first sign of trouble. During the Tech Bubble of the late 1990s, hot money investors pushed growth and tech stocks to extreme valuations,(5) and when the hot money fled those stocks plunged. Between March 2000 and October 2002 (the Tech Bust) the NASDAQ dropped almost 80% and many tech managers performed even worse. The same is true of emerging markets. During the first decade of the 21st Century, hot money (and other investors, of course) piled into emerging markets stocks indiscriminately, forget what the companies were doing or how well they were doing it. When the hot money leaves, EM stocks will plunge indiscriminately.(6)
* Fifth, rapidly growing economies, like rapidly growing companies, are difficult to manage. They tend to be highly levered and small mistakes can be compounded. Because the emerging countries don’t dominate the banking and investment banking world, they largely avoided the 2007-08 financial crisis that gripped the developed world. But, as noted above, that was good-management-by-accident. As I look around the developing world I see alarming mistakes being made in the management of the economies of, e.g., Brazil (corruption, backsliding toward the central economic management of the past), Russia (corruption, state interference, rapidly aging population), India (corruption, impenetrable bureaucracy) and China (corruption, state interference, rapidly aging population) and these mistakes may well devastate the economies of the other emerging countries, which are highly dependent on the Big 4.
* Finally, perhaps a minor point, but emerging markets stocks, like growth stocks generally, tend to be extremely volatile. As everyone knows (that is, everyone who has read my books), volatile returns slow the growth of capital via the phenomenon of variance drain.(7) A less volatile investment (in, say, developed markets stocks) can have a lower return than more volatile stocks and still grow your wealth faster.
In short, advocates of overweighting emerging markets going forward need to come up with a better story than “they’re growing fast.”
(1) I’m speaking mainly of EM equities, but most of what I have to say is also true of EM debt.
(2) The Moneybags© mobile financial app is available as a free download at the Apple App Store or at www.MoneybagsApp.com. The sample portfolio is just that – a sample. It’s not designed to be an appropriate portfolio for any particular investor.
(3) At Goldman Sachs. Give the devil his due.
(4) Other reasons include (a) the view that the developing countries have managed their economies better than has the developed world and (b) the low valuations currently prevailing in EM. But these are shorter term considerations, while I’m speaking longer term.
(5) Many of us fondly remember the days when “eyeballs” mattered more than musty old concepts like “revenues” or “profits.” When Microsoft bought Hotmail in 1997 (a mere one year after it was founded), the price was 100X revenues.
(6) This is what happened during the Asian financial crisis of 1997. Hot money fled and other capital soon followed, nearly causing a global crisis. The MSCI EM Index fell about 50% in three months, and even in the US the Dow plunged 554 points (7.2%) on October 27.
(7) As an oversimplified example, assume you invest $1 million in a stock that rises 50% in year 1 and declines 50% in year 2. You’re not back to your original $1 million – you have only $750,000.
Next up: Submerging Markets? (Part 2
[To subscribe or unsubscribe, drop me a note at GregoryCurtisBlog@gmail.com.]
Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.