Emerging and Frontier Markets: Where the Money Will Flow

by: Harry Long

There is a tidal wave of money, and over the next 100 years it will flow to every Emerging (EEM, VWO, EEB, BKF) and Frontier (FRN, GAF) market on earth which practices prudent economic policies and provides a stable business and political environment.

There are five main reasons why money will continue to flow to these markets.

  1. Cost advantages.

  2. Natural resources.

  3. Debt payments.

  4. Currency undervaluation.

  5. Interest rate differentials (Carry trades).

As the kind reader has already observed, the first four points are rather obvious. A lot of ink has been spilled over cheap labor, abundant supplies of oil/natural gas, the creditor status, and currency undervaluation in Emerging and Frontier countries. This has only been equaled by the inversely proportional legislative response in Developed nations (nothing has been done).

The carry trade has been given a lot less attention. The problem with humans is that we find it very hard to comprehend, and more importantly accept, that largely impersonal forces shape our everyday existence, the fabric of our lives, and the fate of nations. The carry trade is precisely such an impersonal force. Capital goes where it is treated best, like customers for fine dining. When meal sizes are anemic and interest rates are low, customers leave and head for more hospitable, higher yielding environs, or commodities.

A strong argument can be made that in some (but not all) Emerging and Frontier countries, higher interest rates are accompanied by lower risk.

In retrospect, it is quite obvious to many economic observers that the Yen carry trade supplied huge amounts of cheap capital to American markets in the mid to the late 90s, super-charging the bull market and the tech bubble. Decades from now, it will be obvious that our own low interest rate environment fueled a bull market in Emerging and Frontier markets which will go down in the history books as fueling global development far more than any intentional government handout.

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

I concluded the article by saying:

Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

A high level view of geopolitical situation in the next 100 years will be Convergence. Really, the Ultimate Convergence Trade. Political convergence, as Francis Fukuyama and Daniel Yergin/Joseph Stanislaw have argued, has occurred. There is a global consensus that free markets work. There is a global convergence of mass culture (if you disagree, just ask the French. For years, they have bemoaned “Americanization” before anyone else did). There is a global convergence of values—Democracy is good, “Theocrazy” is bad, etc.

The two convergences that we have yet to see are wage rate convergence and interest rate convergence. Of course, countries at equal levels of development will have slightly different wage rates and interest rates tied to differing tax rates, regulatory regimes, labor law, political/civic virtue, economic policy sophistication, central bank policy, etc. But these disparities are minimal compared to the disparities in wage rates and interest rates between Emerging, Frontier, and Developed nations.

A good rule of thumb is that the meat of interest rate differentials will be eliminated only when Emerging and Frontier countries develop to the point that their wage rates converge with Developed nations (in other words, only when they are fully developed). That could take over 100 years, even in a nation such as China (FXI, GXC, HAO). In the meantime, there will be a lot of money to be made by borrowing in dollars and investing in Frontier and Emerging markets.

But, you may say, that's crazy. In 2008, the dollar strengthened, proving that even if investing in Emerging and Frontier markets is prudent during times of political stability, that periodic instability in financial markets makes such investment stance implicitly short gamma, or short volatility. That is probably a fair criticism. Therefore, the rational investor may want to keep leverage fairly low (if it is used at all) and have strict criterion for moving to cash.

However, the U.S. government has made it very clear that it wishes to devalue the dollar. Recent events have made this quite obvious. The recent Federal probe into hedge funds betting against the Euro has been totally misinterpreted by the public and the media. The real story, of course, is that when the Euro drops, the dollar rises. In essence, the government is pressuring these funds to not bet on the dollar and to not allow it to strengthen. Unfortunately, in the future, we may see more of that.

The flow of money adheres to largely impersonal forces such as interest rate differentials. In Global Macro, the sound advice is not to fight it.

If, however, we wish to improve public policy in the developed world, we have to fight the challenges of uncompetitive cost structures, high natural resource prices, a debt-laden economy, and a weak dollar head on.

Disclosure: Long FXI, GXC, no other positions in securities mentioned. Positions may change at any time.