Trash Talking Emerging Markets

Barton Biggs, the former market strategist at Morgan Stanley liked to say that in institutional investing, you don’t really know who your friends are until you have had two quarters of bad performance. The market loves winners and savages losers. In 2013 the Standard & Poor 500 gained 32.4% on a total return basis, the developed markets outside the U.S. gained 22.8% but Emerging Markets lost (2.6%).

It seems the knives are out for anyone or anything in the developing world today. Ruchir Sharma the head of Emerging Markets at Morgan Stanley Investment Management recently wrote an opinion piece in the Wall Street Journal (January 22, 2014). In it he said that the tail wind that has been helping Emerging Markets “converge” with the developing world is no more. Emerging Markets benefitted the past ten years from rising commodity prices and low cost exports to the developed world. Now, commodity prices have cooled and many countries are facing the “middle-income trap” where it becomes more difficult to move from Stage One of development to Stage Two. Once some of the easy work of development has been done, then countries have to tackle the harder issues such as banking, schools and competent regulators.

In my mind the biggest problem facing all Emerging Markets is good governance. You can only ride higher oil and commodity prices so far. In the final analysis it takes good government to put in place sensible development strategies, a fair and open market system, good schools and do all this with systems and people that are not too corrupt. (This last task is tough). The secrets to successful development are pretty straightforward but the implementation is really difficult. The lack of good government is the reason so many Emerging Markets have bounced from boom to bust in the past. Today investors are deserting markets where budgets have gotten seriously out of whack, where inflation has soared or where commodities have been relied on too heavily. The talk is of the Fragile Five (Turkey, Indonesia, South Africa, India and Brazil) but there are other suspects as well.

Even China is wrestling with tougher times. Growth there has slowed from 12% to 8% as the government has tried to shift development from cheap exports and infrastructure building to consumer spending. China sailed through the 2008 world economic slowdown by pumping up government investment to the tune of 10% of GDP. This led to big growth in shadowy non-bank Trust lending. The question now is, how good are these loans?

You get the picture here. Everyone is piling on with criticism of Emerging Markets. The Economist took an amusing poke showing how small Emerging Markets actually are. All of the Russian stock market is about equal to the market capitalization of Proctor & Gamble and Nestle is as big as India. And poor Egypt is trumped by Burger King.

Markets swing continuously between excessive pessimism and excessive optimism. Emerging Markets still have great potential. They have a rapidly increasing middle class with enormous buying power. The Emerging Market trash talk is not going to end tomorrow but we think the next decision will not be when to sell these markets, but when to buy.