The consensus says that you should buy into emerging-market stocks. The consensus is wrong, says Henry Maxey.
The irritating thing about consensus thought in investment is that it can be right lots of the time and then wrong usually spectacularly occasionally. So challenging the consensus doesn't yield a payoff profile that suits human nature; it is, by definition, a lonely existence. John Maynard Keynes summed it up nicely: "Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally."
Why is this currently on my mind? Because I find myself wanting to challenge the current investment obsession with emerging-market equities. Let me start by saying that I am absolutely onboard with the idea that the distribution of global real wealth will be reallocated in favour of emerging markets over the coming decades. However, what I am not freely onboard with, is the notion that investing in emerging-market equities is therefore a good idea.
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Wake up and smell the pumpkin
Today, in particular, I find it frightening to what extent capital flows and opinions are aligned in a consensus that emerging-market equities will outperform developed-market equities for as far as the eye can see. And when I hear some major asset allocators saying, "I know it is a massive consensus, but I just can't see what breaks it", I sense that we're standing at three minutes to midnight and I can smell pumpkin.
It seems to me that investors are in danger of failing to remember, or choosing to ignore, an old chestnut of investment: don't confuse a great company with a great investment. Or translating this into emerging-market investing don't confuse good economic prospects with good investment prospects. Sometimes they will coincide, as they have in emerging markets in recent years, but it can be misleading.
Research suggests that over the long run there is a mild negative correlation between 12-month equity-market returns and underlying economic performance. The rationale is obvious enough markets are influenced as much by liquidity conditions are they are by earnings and discounted cash flows. When there is excess liquidity in the financial system, it can drive a re-rating of equities and vice versa. In other words, when there's more money around, it inflates the price that investors are willing to pay for a set amount of earnings. And when the money gets sucked away, the reverse happens. So when I hear statements equivalent to "buy emerging market equities because that is where the growth is" or "that is where the next x billion consumers will come from", I want to yell: "Taxi!"
For emerging-market equities, liquidity conditions tend to be closely correlated to the US dollar. That's because these economies are biased towards mercantile policies that encourage intervention to stop their currencies from appreciating. In other words, they generally depend to a lesser or greater extent on exporting goods and so want to avoid having a strong currency. As a result, to the extent that monetary and fiscal policy in the US influence the dollar, they also influence liquidity conditions and equity markets in most emerging markets. So far, so not very interesting.
But think of today's context. After the Lehman Brothers crisis, US monetary policy has produced a huge expansion of the Federal Reserve's balance sheet, ie, money printing. This has promoted capital flows into emerging markets and helped weaken the dollar. Combined with emerging markets' own domestic stimulus measures after the crisis, this has driven powerful V-shaped economic recoveries and created massive excess liquidity in emerging economies' financial markets.
All this growth and liquidity was fine when the whole world needed to be dragged back from the brink of a deflationary debt spiral, but that is no longer the case. Today, most emerging markets are suffering rising inflationary pressures, while their developed-market counterparts are still fighting to avoid slipping back into deflation. So global policy-makers no longer face the same common enemy. As a result, they have different incentive structures driving their reactions. For example, inflation is the big bogeyman in China, where it has in the past led to social unrest and political regime change. Whereas in the US, there's more concern about a 1930s-style depression, which Federal Reserve chairman Ben Bernanke promised Milton Friedman he wouldn't let happen again. The resulting frictions can be seen in, for example, recent fears over 'currency wars'.
Now, consider the latest move the Fed's $600bn money-printing spree, quantitative easing 2 (QE2) designed to boost domestic demand and employment. Many are sceptical about how effective this policy will be. They suspect that QE2's primary influence will be outside the US. This will happen via the continued weakness of the dollar and also by a more rapid flow of money (including borrowed money) being invested in emerging markets. This belief supports the emerging-market-bubble scenario that excites stock enthusiasts and worries many Asian policy-makers.
QE2 to the rescue?
It could happen. If it does, I would expect inflationary pressures to accelerate in these economies. This would force governments to make good on their threats to introduce more administrative measures, such as taxes (as Brazil has already done, for example) to discourage flows of speculative money. We would also see attempts to drain excess domestic liquidity to prevent inflation from taking off. I would also expect governments in mercantile nations such as China to continue to allow their currencies to rise more rapidly. In other words, equity markets might rise, but they would become very vulnerable to policy intervention and error. In the meantime, the underlying economies would be under pressure from the effects of a stronger currency and policy tightening. But what if QE2 is more effective than the sceptics believe? Rather than household spending, corporate-sector spending is the key to any recovery. One of the transmission mechanisms of QE2 in this respect is the stock-market. By putting in place 'do what it takes' monetary policy, the Fed shows that it will fight at all costs to prevent deflation from happening. Why does this help? Because for now, even though investment-grade companies have access to funding at historically low rates, many aren't taking advantage. And that's partly because they can't rule out an extreme deflationary environment, which would be a disaster for any heavily indebted companies.
Putting hopes on a stronger dollar
But if the Fed cuts off this negative 'tail' risk of extreme deflation, it means that even if corporations and investors forecast a low future growth environment (which in itself provides little incentive to invest in extra capacity), they still have an incentive to borrow and invest in existing capacity, ie, to conduct share buy-backs and acquisitions. That's because even under low-growth scenarios, returns are more positive than their marginal cost of capital. The net effect is to encourage a re-rating of the stockmarket, allowing it to disconnect from its relatively lacklustre likely future earnings growth. In other words, if companies use cheap money to buy their own shares and take over rivals, that will push up stock prices even if overall prospects are rather dull-looking.
If this happens, bank borrowing will also pick up (because not everything will be done through corporate bond markets), broad money growth will start to recover, consumer confidence and corporate confidence will rise, and eventually expansionary capital spending and higher employment will follow. By definition, employment and the housing market will lag the stockmarket in this environment. This will encourage policy-makers to keep short real interest rates low or negative for longer. Despite this, I believe the dollar would stabilise and begin to strengthen due to expectations for improved economic prospects and a steepening yield curve.
Once the dollar starts to strengthen into a rising US stockmarket, the scene will be set for developed-market stocks to outperform emerging-market ones because the context for emerging markets suddenly looks less benign. Capital inflows slow down and possibly reverse, domestic liquidity conditions tighten, yet inflation remains a threat. Economic growth in emerging markets may not be disastrous, but equity markets could struggle and would, I believe, underperform relative to developed markets.
To conclude, the big picture set-up is this: the benign, cooperative dynamics of 'Bretton Woods II' capital flows between the US and emerging markets that existed before the credit crisis are gone. We're left with countries battling it out to save their own economies, either from inflation or deflation, whichever way they can. In particular, monetary policy in the US is being set with the domestic economy in mind, even if the impact of Fed policy is global. So what matters is how much quantitative easing we need. If QE2 works, the dollar should eventually stabilise and emerging-market equities will underperform. If QE2 doesn't gain traction domestically, it is possible that emerging-market equities could get 'pumped up'. But with policy-makers, certainly in emerging economies, alert to the threat of inflation, they are likely to try to protect themselves from any boom and bust that results from Fed policies. So if emerging markets try to bubble up, it is likely to be messy and short-lived.
For my money, I'd prefer an investment that is as crowded as the Delhi Commonwealth Games, which would benefit from a stronger dollar and adequate nominal global GDP growth, and which doesn't lose out if my urge to turn against emerging markets proves premature: Japanese domestic equities. Or, as I like to think of them, pumpkins that are able to turn into treasure at the stroke of midnight.
Henry Maxey is chief investment officer at Ruffer .
