While they’re clearly too big to ignore, the momentum of emerging markets may be starting to roll over. At least that’s what Paul Ehrichman, head of global equity, with Global Currents Investment Management suggested in his keynote address at Legg Mason’s Rethink 2010 Investment Symposium on November 4 in Toronto.
While nations such as China and India are being touted as the solution to—or at least a means of diversification from—the debt woes of developed nations, Ehrichman warns against investments in emerging markets-focused exchange traded funds (ETFs) and passive management strategies.
China: it’s later than you think
To be fair, GDP growth rates have risen consistently in many developing nations. China, for instance, has grown by an average of 9.3% annually over the last 20 years, and the World Bank just today raised its forecast for the country’s economic growth in 2010 to 10%.
But that’s part of the problem. You want to buy into emerging markets when they’re distressed, not when they’re hitting annual double-digit growth rates. This, Ehrichman says, is because emerging market country GDP growth and stock market performance are inversely correlated—so as real GDP growth rises, real stock returns fall. The fact that developing nations are growing, then, is bad news for returns.
In addition, emerging market dilution (that is, the price level of the average stock to market cap ratio) sits at about 10% per year—meaning you need to increase your investment by 10% annually to generate similar returns.
So are you too late to jump on the emerging market bandwagon? No, says Ehrichman. There’s most certainly still value in emerging markets. But be careful of the indiscriminate buying we’re seeing, where all companies are valued equally, with complete disregard to quality. That means investing in passively managed funds and ETFs focused on emerging markets is risky business.
The U.S.: it’s earlier than you think
Contrast that with the current position of the United States. Ehrichman asserts America will continue to grow. And while things may seem a little desperate now, he urges everyone to consider the following facts.
- The U.S. produces 25% of the world’s goods and services—and is the biggest producer of manufactured goods (larger than Japan and China combined).
- The country’s oil production is 85% of Saudi Arabia’s, and is close to Russia’s output. It’s also the world’s second-biggest producer of natural gas.
- At 31 people per square kilometer, the U.S. is still under-populated and has three times the global average of arable land per capita, leaving no food-security issues.
- As a bi-coastal country, America has access to markets across the Atlantic and Pacific oceans.
With all this in mind, Ehrichman says, “It’s hard to see America collapsing.”
Europe: Too late
Part of the problem with Europe, Ehrichman suggests, is it’s not one country—and we’re likely to see the return of the “two-speed Europe” shortly. In his opinion, the E.U.’s economic and monetary union was a Ponzi scheme for the Capital Adequacy Directive, and it’s quite possibly game over for the PIIGS, and maybe even France too.
“The socio-economic fabric of Europe—the welfare state—is failing and will test political and social stability,” he says. The euro is at a turning point, and there are cultural, capital, labour and geographic challenges ahead as Europe’s austerity programs start to bite.”
Changing investment landscape
With all the uncertainty and upheaval then, what’s an investor to do? Ehrichman has a few suggestions.
- Trade Asia bullishly (but cautiously) and Europe bearishly. • Remember the 80/20 global arbitrage.
- Japan is the best bet for reflation (Ehrichman referred to Mitsubishi Corporation as an “interesting” play right now).
- Emerging market downside protection is cheap right now—so buy it!
- Consumer infrastructure is a better bet than industrial infrastructure—especially Chinese water infrastructure plays.
- It may be time to revisit Africa—South Africa and Egypt, primarily.