The bulls' case for buying emerging markets this year is simple.
Emerging markets might not be as cheap as they once were compared to developed markets. But at least they represent countries that are showing some real GDP growth.
Buy stocks in the West and you are buying into ex-growth economies paralysed by political failure, private debt and popular denial.
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Buy into emerging markets and you are buying high-growth economies with either vibrant democracies (India) or command governments skilled in economic manipulations (China). Case closed.
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Or is it? We aren't so sure.
Emerging markets aren't cheap enough
Earlier this week I wrote that it is hard to find a good reason to hold emerging markets this year.
It used to be that you could buy most of them purely on the basis that they were cheap. When developed markets traded on average price to earnings (p/e) ratios of seven to nine times and developed markets traded at around 17 times, it all made sense. By buying emerging markets, you were making a perfectly sensible convergence trade.
Buy them today and you are not doing anything of the sort. The developed market premium is tiny. It's barely enough to compensate the investor for the higher governance risk in the average emerging market.
This matters. Yes, emerging market economies are still growing faster than those in the West. But as we always point out, economic performance is no real guide to stock market performance.
Short-term performance is about money flows; long-term performance is about price (the cheaper you buy, the better the long-term return).
On top of this,it isn't a given that the performance of emerging economies is going to be that great this year anyway. In fact, they look pretty "poorly positioned in a low growth world", as Deutsche Bank puts it.
We know that China is at best slowing softly and at worst already in the middle of a hard landing. That will have a nasty impact on the commodity-dependent economies (such as Brazil and Australia).
We also know that the East has in no way yet decoupled from the West: China may want consumption to drive its growth, but the empty shopping malls and unsold apartment blocks across the country tell a clear story of investment running way ahead of demand.
The emerging market boom was a product of the credit bubble too
The truth is that much of the growth in emerging market economies in the last few years has been as much about a massive credit and liquidity cycle (just like the ones we saw in the US in the 2000s and Japan in the 1980s) as anything else.
Consider credit-to-GDP ratios. Start with an index of one in 1996 and, according to numbers from SLJ Partners, the ratios for Brazil, Russia, India and Turkey have now risen to 1.7, 5.8, 2.1 and 3.0 respectively.
China is tougher to figure out, thanks to the huge shadow banking system off-balance-sheet lending could be 25% of GDP but SLJ puts the increase in China's ratio at about 85%.
In other words, the importance of credit to the growth of all the emerging market economies has surged in the past decade or so. These cycles have been driven in part by domestic lending, but also by huge foreign inflows, which in turn were driven by loose monetary policies in the US, UK and Japan.
In the three years up to 2008, the cumulative capital flows going into emerging markets reached $70bn. Now they are up to $187bn. Yet that wall of money hasn't delivered investors good returns over the last few years.
You can argue about why this is the case indefinitely. It could be about price. It could be about monetary tightening in China. Or it could be down to the fact that the massive new supply of equity from listings of state-controlled companies has swamped demand.
But the key point is that its withdrawal will all but guarantee far worse returns.
Swap your emerging market currencies for dollars
So what might make these money flows reverse? And when? 'When' is always the tough bit (I'll go with sooner rather than later), but SLJ offers three possibilities for the 'what' bit.
First up is more of a slowdown in developed markets. This is a pretty strong possibility given the state of the eurozone.even the World Bank is now prepared to recognise this as a threat. It warned this week that "escalation of the crisis" in Europe "would spare no one" and cut its forecast for emerging market GDP growth in 2012 from 6.2% to 5.4%.
Secondthat money stops floodinginto emerging markets as deleveraging continues across the West. Note that there was a decline in Chinese foreign reserves in the last quarter of 2011 for the first time since 1998.
And third is a "more assertive US dollar" continuing to challenge the view that emerging currencies are the place to be. The dollar isn't expensive anymore (the fundamentals may not have improved, but remember that currencies are all relative). Any cyclical turndown in emerging markets, "even if China avoids a hard landing", could lead "to a powerful rally in the dollar" against most emerging market currencies.
We've been in favour of holding some exposure to emerging market currencies for some time now.Regular readers should have done well out of it. However, we doubt China can avoid a hard landing. We are also concerned that the credit cycle that has been driving emerging market growth is getting a little long in the tooth.
So it might be a good time to think about taking some profits from the trade and recycling them into dollar holdings. And if you must keep money in emerging markets (which most investors now feel they must) stick with India. My colleague Cris Sholto Heaton wrote about how to go about this in last week's issue of MoneyWeek: Investors should look forward to an Indian summer. If you're not already a subscriber, subscribe to MoneyWeek magazine.
Otherwise, you could try and protect yourself in the same way that Chinese investors are by buying gold. As our Australia-based colleague Greg Canavan points out, China's imports of physical gold via Hong Kong have soared in recent months. In November alone, gold imports totalled nearly 103,000kg.
"Are Chinese citizens trying to protect themselves from falling property and equity markets? With deposit rates less than the inflation rate, there's no respite by placing funds in the banks either. Gold seems like a sensible option."
This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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