Universal truths of investment turned upside down

Developed markets once offered security and income, while emerging markets offered rapid growth, says Matthew Lynn. But thanks to the global crisis, that's all changed.

Some things have always seemed universally true in the financial markets. Never invest in an airline. Currencies that end with a vowel always end up being chaotic. Nobody ever went broke because they had too many Swiss francs. And, perhaps most universally of all, that emerging markets were for rapid growth, but the developed markets for security and income.

The first three are still true. But the final one is about to change and may have already done so. The developed and emerging markets have traded places and it is now the new nations of eastern Europe, Asia and Latin America that offer more security and a higher income for investors than the old world of Europe, America and Japan. For the markets, this is a seismic change.

Traditionally, while you might allocate 10% or 20% of your portfolio to those nations, depending on your risk appetite, and how much income you were willing to forego, for dividends and security you'd stay with the developed world. Now, the emerging markets increasingly pay higher dividends. And it is the developed markets that are hyper-volatile.

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Just look at recent market movements. Take the German DAX. You might think of it as a dull, conservative index, but it has been yo-yoing up and down like a squirrel on amphetamines. There was a 30% fall between May and October, but it has risen by another 30% since then. Since the definition of a bear market is a 20% correction, it has been through both a bull and bear market in less than a year. There is nothing stable about that.

Most other major markets have been just as volatile. The S&P has risen by 25% since the wobble last autumn, and the FTSE by almost as much. If they fall by another 20% as the latest act in the Greek drama unfolds, no one will be surprised.

The point is simple. The developed markets have become extremely volatile. True, the emerging markets bounce around as well. But right now they move in response to events in Europe or America, and often to a lesser degree than the main developed markets.

Meanwhile, emerging market dividends are rising. Take eastern Europe. According to research by investment bank Renaissance Capital, the MSCI Eastern Europe Index in 2011 paid 3.1% in dividends, compared with 4% for the Euro-Stoxx 600. As recently as 2007, the figures were 1.7% and 3% respectively.

So the gap has narrowed from 50% more income in the developed half of the continent to only 25% more. The same is true in the Far East. Asia ex-Japan now has an equity yield of 3%, only slightly below Europe. That is more than the 2.1% yield on the S&P 500.

Just as significantly, emerging markets yields are rising. A quarter of the world's stocks yielding more than 3% are in Asia. Russian companies are pushing up dividends fast. Energy giant Gazprom has tripled its dividend since 2009 and now has a yield of 4.5%, on a par with British and American rivals. The era when emerging markets didn't pay out much income is clearly over.

Of course, it could just be a coincidence. The developed world has just been through the credit crunch, and now the euro crisis. Stockmarkets have been through a period of extreme volatility. In the next few years, things could return to normal. At the same time, dividends were always going to rise in the emerging markets. As countries get wealthier, and companies grow bigger, they generate more cash and investors demand higher income. A convergence of yields across the world was always on the cards.

While there is some truth in that, there is something more profound going on. The developed and developing world are trading places. The developed world now has many of the characteristics of an emerging market high debt levels, political instability, and periodic currency crises. Emerging markets now look relatively stable, with low debts, secure currencies and sometimes more secure governments as well.

Take debt in Eastern Europe. Czech government debt stands at just 42% of GDP. In Poland, it is 57%. In Russia it is 12% and in Estonia 6%. In Germany and France, debt levels are more than 80% of GDP, and they are no better in Britain or America. And Japan? Don't ask. Household debt levels are just as low. Russian consumer debt is about 10% of GDP. In Poland, the figure is 33%. And in the developed world? Again, don't ask.

Countries with low debts are more stable just as companies and households with lower debts are. With balance sheets in decent shape, they are better placed to withstand fluctuations in the economic cycle. Nearly all the low debt countries are emerging markets.

Slowly investors are realising what is happening. Emerging markets offer greater security and now higher yields. With younger populations, smaller governments, less welfare and lower taxes, they grow faster. Increasingly, the question may well be not how much money you want to have in the emerging markets but why leave any at all in the developed world?

This article was originally published in MoneyWeek magazine issue number 577 on 24 February 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.