Emerging markets – Have you missed the boat?

By Nancy Turner | November 5, 2010 | Last updated on November 5, 2010
3 min read

While they’re clearly too big to ignore, the momentum of emerging markets may be starting to roll over. At least, that’s what Paul Ehrichman, head of Global Equity for Global Currents Investment Management suggested in his keynote address at Legg Mason’s Rethink 2010 Investment Symposium.

While BRIC nations such as China and India are being touted as the solution to – or at least a means of diversification from – the debt woes of developed nations, Ehrichman warns against investments in emerging markets-focused ETFs and passive management strategies.

China: it’s later than you think

To be fair, GDP growth rates have risen consistently in many developing nations. China, for instance, has grown by an average of 9.3% annually over the last 20 years and the World Bank just raised its forecast for the country’s economic growth in 2010 to 10%.

However, that’s part of the problem. The fact of the matter is you want to buy into emerging markets when they’re distressed not when they’re hitting annual double-digit growth rates. This, Ehrichman says, is because emerging market country GDP growth and stock market performance are inversely correlated – so as real GDP growth rises, real stock returns fall. The fact that developing nations are growing is bad news for returns.

In addition to that, emerging market dilution (that is, the price level of the average stock to market cap ratio) sits at about 10% per year – meaning you need to increase your investment by 10% annually to generate similar returns.

So are you too late to jump on the bandwagon? Not according to Ehrichman. There’s still value in emerging markets but be careful of indiscriminate buying, where all companies are valued equally with complete disregard to quality. That means investing in passively managed funds and ETFs focused on emerging markets is risky business.

Source: Societe Generale Research, 2010.

The U.S.: It’s earlier than you think

Despite what many may think, Ehrichman asserts America will continue to grow and while things may seem a little desperate now, he urges us to consider the following:

  • The U.S. produces 25% of the world’s goods and services and is the biggest producer of manufactured goods (larger than Japan and China combined).
  • The country’s oil production is 85% of Saudi Arabia’s and is close to Russia’s output. It’s also the world’s second-biggest producer of natural gas.
  • At 31 people per square kilometer, the U.S. is still under-populated and has three times the global average of arable land per capita, so there are no food-security issues.
  • As a bi-coastal country America has access to markets across the Atlantic and Pacific oceans.

With all this in mind, Ehrichman says, “It’s hard to see America collapsing.”

Source: Societe Generale Research, 2010.

Europe: Too late

Part of the problem with Europe, Ehrichman suggests, is it’s not one country – and we’re likely to see the return of the “two-speed Europe” shortly. In his opinion, the E.U.’s economic and monetary union was a Ponzi scheme for the Capital Adequacy Directive and it’s quite possibly game over for the PIIGS and maybe even France too.

“The socio-economic fabric of Europe – the welfare state – is failing and will test political and social stability,” he says. The euro is at a turning point, and there are cultural, capital, labour and geographic challenges ahead as Europe’s austerity programs start to bite.

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Changing investment landscape

With all the uncertainty and upheaval…What’s an investor to do? Ehrichman has a few suggestions:

  • Trade Asia bullishly (but cautiously) and Europe bearishly.
  • Remember the 80/20 global arbitrage.
  • Japan is the best bet for reflation. Ehrichman referred to Mitsubishi Corporation as an “interesting” play right now.
  • Emerging market downside protection is cheap right now – so buy it!
  • Consumer infrastructure is a better bet than industrial infrastructure – especially Chinese water infrastructure plays.
  • It may be time to revisit Africa – South Africa and Egypt, primarily.

Contrarian yes, but also food for thought.

Nancy Turner