No asset class has been beaten more severely this year than emerging markets. Since the March, 2011 high, the iShares MSCI Emerging Market ETF (EEM) has plunged from $48 to $35.80, a loss of 25%. Individual markets have fared far worse. The Market Vectors Indonesia ETF (IDX) has taken a 39% haircut, while the Powershares India Portfolio ETF (PIN) has cratered by 46%.
It wasn’t supposed to be like this. These countries boast GDP growth rates of two to four times those found in the developed world. Many, like Chile (ECH) and Indonesia (IDX) are endowed with abundant natural resources. India (PIN) offers one of the world’s most attractive demographic pyramids, a precursor to stable long term growth.
The Philippines (EPHE) boasts a great, low waged, educated labor force. It is no accident that to subscribe to the San Francisco Chronicle your call gets directed to an obscure location 200 miles south of Manila, where call center workers live well on $2,000 a year.
You can blame China for starting the malaise. The Middle Kingdom is the largest customer for many of these countries, and successful efforts to throttle back the economy to control runaway home price inflation have spilled far beyond its borders. Since 2007, China’s economy has slowed from a near 14% annual growth rate to a probable 7%. This is a rate not to be sneezed at, but it is still quite a hit. Weak emerging economies then slow China further, creating a vicious negative feedback loop.
China isn’t the only problem. Most emerging nations are highly dependent on imported energy, and are in effect shorts on oil. So when Middle Eastern turmoil drives Texas tea up 28% over the past five months, as it has, balance of payments bleed. This has pummeled their currencies, boosting the local cost of fuel even further. In some countries gasoline costs have soared by more than 50% since the spring. This is terrible for their economies.
The big surprise is how much Ben Bernanke’s “taper” thoughts are pounding the emerging markets. Much of the excess cash that the Federal Reserve has created over the past five years has poured into the emerging space, boosting share prices and ETF’s to heady heights. Cut off that supply, even by a piddling $5 billion a month, and everyone tries to leave the party at the same time. The price action has been reminiscent of the proverbial flash fire in the movie theater.
Excess liquidity has in fact turned the emerging markets into “reach for yield” assets, much like master limited partnerships, sovereign debt, junk bonds, municipal bonds, and REIT’s. All of these asset classes have held hands jumping over the cliff since April, when the “taper” talk began. When investors take inordinate risks for small, incremental improvements in returns, it always ends in tears.
Once emerging markets started going down, all the dirty laundry came out. Tales of corruption have always been endemic to the region. China has started arresting foreign drug company executives for bribery, a classic case of the pot calling the kettle black. The human rights records of several are less than sterling. Having spent time in jail in some of these places because of what I wrote, I more than sympathize.
What’s worse, some of the emerging fundamentals have deteriorated. Once, you bought these countries because they had little debt, a legacy of dismal credit ratings in the seventies and eighties. What did the Fed’s easy money policies accomplish here? Rising debt levels, both at the national and corporate level. Worst of all, some countries have been borrowing from abroad to subsidize fuel prices to lessen the recent price spike. That weakens national finances at an exponential rate.
It all adds up to a perfect storm for emerging markets. Think of them as a short oil/short dollar/long junk play. Ouch! With the way they have been trading, you’d think their largest export was venereal disease!
Which is all why I am starting to get interested. For many years, emerging market companies sold at large premiums to American ones. They now sell at a 35% discount. The long-term bull case is still valid. Watch the bond market. If it rallies hard in the wake of the Fed’s taper decision, as I expect, then it will be off to the races for emerging markets once again.
But it won’t be your father’s emerging bull market. Forget about the BRIC’s (Brazil, Russia, India, China), which are last year’s story. Just mindlessly buying the (EEM) won’t work anymore either. This is no longer an index play.
In the next cycle single country picks will be the name of the game. What’s on my short list? Mexico (EWW), South Africa (EZA), Indonesia (IDX), Thailand (THD), Malaysia (EWM), the Philippines (EPHE), Columbia (GXG), and Chile (ECH). Industry selection will also be important, with a move away from export industries towards domestic consumption called for.
Maybe it’s time to add Thailand to my short list of potential vacation destinations?