Why Investors Need to Reexamine These Emerging Market Myths

by: Steven Jon Kaplan

In recent years, there has been a lot of media hype about "ever-growing emerging markets" which will allegedly "enjoy double-digit GDP growth for many decades to come" and "which have demonstrated an inherently superior structure to developed markets which will enable them to continue their equity outperformance for the foreseeable future". Let's consider these claims, and why emerging markets have enjoyed above-average growth in recent decades, and what is likely to happen in the future.

It is almost taken for granted that many emerging markets will continue to experience higher growth rates than more established countries including the United States, the U.K., and most of the countries in Western Europe. However, it is usually assumed to be the result of a superior educational system, a more coherent set of cultural values, high population growth, vast natural resources, and numerous other factors--all of which are almost completely irrelevant to the issue of economic vibrancy. Let's focus on the single most important feature of emerging markets, which is the availability of credit.

Developed markets have enjoyed relatively easy and plentiful access to credit in numerous forms for decades or longer--mortgages, credit cards, auto loans, installment payments, low money down payments, government-guaranteed borrowing, and numerous related institutions. In sharp contrast, much of the rest of the world was on a cash-only basis until just twenty or thirty years ago (or even less, in some "frontier" countries including Colombia, Mongolia, and Uganda).

If you live in an all-cash economy which suddenly begins to use credit, there will be an immediate surge in spending--and which will create a domino expansionary effect. When someone borrows money, that money quickly finds its way into the real economy. Over time, as that loan has to be repaid, this will have a gradual drag on the economy over a period of several years or more. However, the immediate impact is invariably positive. In any nation where most of the GDP growth is caused through the expansion of local businesses, as in China and India, the fact that many millions of people will suddenly have access to credit will almost certainly create double-digit increases in annual revenue for many sectors of the economy.

This higher rate of growth can only continue as long as credit continues to become more readily available to an ever-increasing segment of the total population. Eventually, as in the developed world, a point of saturation begins to be approached. There are still those who do not have access to credit, but they will eventually consist primarily of those who are not creditworthy due to their limited personal circumstances, or the minority of those who simply refuse to borrow money under any circumstances.

Once this saturation point is reached, further credit expansion slows dramatically. This has the immediate effect of causing lower rates of economic growth. In the longer run, the reality of widespread loans having to be repaid will have an even more negative effect on the economy, especially during times of recession when assets become less valuable, while loans are not diminished in magnitude. In relative terms, then, the loan-to-asset ratio of much of the population will dangerously increase.

While the impact of credit during an economic recession has mostly been ignored by the media, it is a critical issue. In India, the inability to repay small business loans, often called microloans or microcredit, has led to a growing disaster in which numerous individuals and even entire villages have been forced into the equivalent of foreclosure. This article ("Understanding India's Microcredit Crisis") from Aid Watch compares the microcredit situation in India's villages to the U.S. subprime mortgage crisis of recent years.

The Wall Street Journal had a similar report ("Microfinance: Is Grameen Founder Muhammad Yunus a Bloodsucker of the Poor?"). As with all forms of borrowed money, personal and business loans are considered to be wonderful when the economy is expanding. But as soon as an actual or potential contraction appears likely, the woes of paying back money during a time of stress take center stage.

In China, the availability of credit has greatly contributed to the housing bubble in that country, which has reached an extreme never seen before in recorded history. A one-child policy has caused a major shortage of women relative to men, thereby creating potential social discord at the same time that an inevitable housing-price collapse will cause a recession. Since most investors have been anticipating positive double-digit growth for China to continue for many more years or even decades, the surprise impact of negative GDP growth will have a devastating effect on the ability to repay credit. In addition, credit standards are likely to be tightened as has been the case in most of the developed world in recent years, which will exacerbate any contraction. These issues were examined thoughtfully by Leigh Skene in his Lombard Street Research essay ("China: Saviour or Predator?") regarding China's future.

It is true that the average annualized increases for emerging-market equities have exceeded those of developed markets by notable percentages during the last few bull markets. However, during bear markets, emerging-market bourses have consistently declined substantially more than in developed markets. The bear markets of 1997-1998 and 2008, in particular, were devastating for emerging markets around the world, and this is likely to be the case in their respective 2010-2012 bear markets. As originally tabulated by Morningstar and reported by Hedgeweek, 2008 saw especially severe losses for emerging markets across the board (see Emerging Market Equities Suffered Most in 2008, Says Morningstar).

Probably one of the most important observations of the last bull market is that emerging markets began to establish uptrends during the fourth quarter of 2008, especially during the second half of November 2008, whereas most developed markets continued to set new lows through early March 2009. Thus, emerging markets were ahead of developed markets in establishing bullish chart patterns by 3-1/2 months.

Interestingly, the same rule appears to be in force at the present time--but in reverse, as China (NYSEARCA:FXI), Colombia (NYSEARCA:GXG), India (NYSEARCA:INP), Thailand (NYSEARCA:THD), Indonesia (NYSEARCA:IDX), Hong Kong (NYSEARCA:EWH), Singapore (NYSEARCA:EWS), and many other emerging markets began downtrends during the first several trading days of November 2010. The S&P 500 and many other developed-market equity indices didn't peak until February 18, 2011, which again was 3-1/2 months later.

If this pattern holds, it illustrates that emerging markets lead the rest of the world into major bull and bear markets alike.

One factor which is likely to be a major drag on emerging markets is the relative behavior of top corporate insiders during the past year, versus amateur investors. Bloomberg Businessweek reported on intense selling by the highest-ranking executives in India in this analysis ("India Insiders Sell Stocks at Fastest Pace Since Peak") from the fourth quarter of 2010. Just as foreign investors were pouring into Indian equities, top executives in India were unloading shares at their most rapid pace since the previous unsustainable equity peak in January 2008. Since insiders generally only sell if they anticipate a substantial percentage decline to follow, this increases the probability that we have begun a major bear market for emerging-market equities rather than merely a correction. All of the emerging markets listed in the previous paragraph have been in downtrends for four months, thereby increasing the likelihood of an extended slump to persist through 2012.

As emerging markets decline, their currencies are likely to similarly slump versus the U.S. dollar, just as they did during the last bear market and probably repeating their percentage pullbacks of 30%-35% in U.S. dollar terms. As the greenback rallies strongly, one of the best investment choices will be TLT, which is an exchange-traded fund of U.S. Treasuries averaging 28 years to maturity.

In the second half of 2008, TLT surged more than 40%, making it as profitable as many short-sale positions with far less risk. TLT is my largest current holding and I have been aggressively purchasing it since the middle of December 2010, especially whenever it dips below 90 dollars per share. TLT yields 4.3% annualized, credited monthly, with an annualized expense ratio of 0.15%.

One potentially positive long-term omen is that each of the last several bull markets has been accompanied by stronger relative performance of emerging markets versus developed markets. This outperformance has subsequently been reversed by the bear markets which occurred in between those bull markets, but this pattern implies that the next major bull market for emerging equities--which will begin perhaps in 2012--should be even more powerful in terms of total percentage gains.

Africa, in particular, has been generally ignored by many investors, as is evidenced by the paucity of exchange-traded funds which specialize in African countries. It will be necessary to be patient for another 1-1/2 to 2 years, to enable valuations in all emerging nations to complete their respective bear markets, and then to select for purchase among those sectors which have become the most irrationally oversold and undervalued near their next major bear-market bottoms.

Disclosure: I am long TLT.

Additional disclosure: I am short SLV, QQQQ, and EWY.