There is a general consensus that emerging market equities and economy will do well in the long-term, as compared to developed markets. I also believe the same when it comes to talking about the long-term outlook for the economies.
However, there are bound to be phases in the short to medium-term, when the developed markets outperform the emerging market equities. Therefore, for investors looking to benefit from medium-term fluctuations in markets, it is of paramount importance to identify the phases where certain markets might outperform the others.
Just as an example, the U.S. market is currently down by 12% from its 2011 peak of 12,810 in April. During the same period, the Chinese markets have declined by 17%. Further, the U.S. markets almost reached the highs of April in July 2011 before correcting again.
On the other hand, the Chinese markets were significantly below their April 2011 peak in July and have corrected even further. The same is evident from the two charts below giving the performance of the U.S. indices and Chinese indices in 2011.
[Click all images to enlarge]
Dow Jones Index YTD Performance
Shanghai Composite Index YTD Performance
Clearly, the U.S. markets have outperformed the Chinese markets for a major part of 2011. In my opinion, this trend is likely to continue in the foreseeable future. In line with this expectation, if I had an option just to invest in one of the two indexes, I would go for investment in the U.S. equities than Chinese equities.
Discussed below are the major reasons for this rationale.
There are two major reasons, which largely explain the market behavior I have discussed above. The first is that the U.S. economy is struggling to grow while the Chinese economy has witnessed steady growth and even overheating in some sectors.
The second reason, closely related to the first, is that the policymakers in the United States are adopting an accommodative monetary policy, while policymakers in China are tightening monetary policies. The charts below give the interest rate trend from January 2007 to August 2011 for the two countries.
Clearly, China has been trying to tighten monetary policies in order to control inflation, which is at 6.5% currently. Further, the real estate market (in several key cities) has been overheating and policymakers are taking measures to control any further irrationality in real estate prices.
As a result, the Chinese economy, which experienced robust growth even after the global downturn, is slowing down. There is no clarity on the extent of slump in different sectors and in the economy. This uncertainty is being reflected in the equity markets. Moreover, since markets have been gradually trending down, it is telling us that a meaningful slowdown is on the cards.
From the policymakers’ perspective, this is what they would ideally want in the near-term. There is no doubt about the long-term growth for the economy. However, in the short-term, slowing down the economy might be a better option. Therefore, in my opinion, the markets would remain in an uncertain zone with further downside expected if the near-term growth numbers are dismal.
On the other hand, the monetary policies in the United States are highly accommodative with the policymakers prepared to do more in order to prevent another recession. As the economy shows further signs of weakness, one can expect more stimuli (in some form or the other). Such an action has the potential to artificially boost the asset markets and also support the economy to some extent.
Therefore, any further correction in equity markets (signaling weakness in economy) will be offset by policy action of more quantitative easing. What I want to emphasize here is that the U.S. equity markets might remain stable or bounce back relatively faster than the Chinese equity markets, where policymakers are intending to slow down things.
In conclusion, the Chinese economy might be slowing down, but so is the U.S. economy. However, the difference in policy action in the two countries would primarily determine the markets to be invested in the near-term. From that perspective, the U.S. markets look relatively more attractive and in all probability would outperform Chinese equities in the foreseeable future.