I had lunch in midtown with my friend Fred, a veteran Street salesman, who handed me a glossy brochure from an emerging market fund manager who had visited his office. The pitch was (Surprise!) emerging markets have underperformed, investors are “underweight” EM relative to the MSCI global index, the markets look cheap, and it’s time to buy.
It’s not just dedicated fund managers who like EM. One of the biggest and best wealth managers is telling clients to have a total equity allocation of 34.5%, of which 6% should be in EM. They also want you to have 4% in commodities, which are highly correlated with EM. Therefore more than a quarter of your “risk assets” are in EM or EM-correlated commodities. [(6+4)/(34.5+4)=0.26]
I have a big problem with EM, which I described a year ago (see “Emerging Market for Cowards,” Jan 5, 2014). U.S. equities are risky enough and periodically drop more than 20%. When you buy EM stocks, you are embracing several new layers of risk, which are auto-correlated, and which you don’t need to accept to get exposure to the economic growth in emerging markets.
Four Big Risks
Because emerging economies are financially risky, their currencies periodically plunge. Most of them run current account deficits; i.e., they borrow from abroad. This is fine so long as the money is spent on productive assets such as factories, but often it goes for consumer goods, presidential palaces, boondoggle infrastructure, weapons, or (in the case of Russia) apartments in London and Manhattan. Much of the borrowing is in dollars, so if the EM currency declines the effective debt burden increases dramatically. To defend its currency, the country raises interest rates and slashes government spending; a severe recession ensues. (See Russia, 2015.)
It gets worse. Many (not all) emerging markets rely on commodity exports and so are hurt by weak commodity prices, which are inversely correlated with the dollar – strong dollar, weak commodity prices. So U.S. investors in EM get hit with the double whammy of weak EM currencies and weak EM economies.
Third, corporate governance, which sometimes sucks in the U.S., is even more problematic and opaque in emerging markets, for three reasons: weaker standards of corporate governance, more government corruption, and the difficulty U.S. investors have in monitoring far-away companies operating in an alien business culture.
Then there is economic policy, which is bad enough in the U.S. (see Obama, Barack). EM economic policies are often hostile to capitalists because they are socialistic (India, Brazil), exceptionally incompetent (India, Argentina), corrupt (Russia, India, China, Turkey), or distorted by political instability (Thailand, Middle East).
Bad Timing
Because they are so risky, you need a huge “risk premium” (i.e., very low valuation) to justify investing in emerging markets. That means buying after a crash. Unfortunately that is not when Wall Street will tout EM; brokers will wait until the markets have recovered and they can tell clients “If you had owned EM over the past year, you would have done better than owning boring U.S. stocks. But there’s still time to diversify into EM, which will cut the volatility of your portfolio.”
Rather than trying to play this complicated, risky game, normal investors who are not closely monitoring the elections and economic performance of India, Brazil, Russia, Argentina and Turkey should simply purchase U.S. or European multinationals, along with an occasional high-quality EM stock such as Samsung. These companies produce what developing nations need, whether it is iPhones, Nike running shoes, Diageo whiskey, Philip Morris cigarettes, Monsanto seeds, Boeing aircraft, or Schlumberger oil services. Leave the currency risk to the Treasury Departments of these companies.
Copyright Thomas Doerflinger 2014. All Rights Reserved
