I’ve just updated Current Market Tactics.
Maybe a correction isn’t in the offing. Too bad. On the other hand, upside momentum seem to me to be waning.
Category Archives: emerging markets
problems in emerging countries (ii): financial markets
First, a small–but important–distinction. There are emerging markets located in wealthy nations. They focus almost exclusively on trading of local securities in countries where not many companies are listed and where locals have little interest. Germany used to be one such backwater–and still is, to some extent. Eastern European countries, members of the EU but with rudimentary securities markets, are another.
Then there are emerging countries, and their stock markets. This latter group is what I’m writing about today.
emerging countries’ markets
The securities markets in emerging countries have two important characteristics that I think most investors are unaware of:
1. There’s very little local demand for stocks or bonds. There are usually no institutional investors, because there are no pension funds. The average citizen works a 60-hour week to make, say, US$125. He has no money to put at risk by buying bonds or stocks. He may not trust his local financial institutions. Instead, he may buy gold and bury it in the back yard.
This means that the local markets rise and fall on demand from foreigners. When times are good, foreigners pile in and financial instruments soar. The longer the boom, the deeper into unknown waters (smaller markets, micro-cap stocks) they wade.
Eventually, the tide turns. The first to leave quickly exhaust local demand. The rest can find no one to sell to. Around 1990, for example, developed country investors “discovered” Indonesia toward the end of a long bull run in emerging markets. After the party wound down, it was at least two years before investors with large holdings in Indonesian stocks could even begin to pare them.
2. Local rules can change quickly. Changes can apply either to everyone or just to foreign investors. Capital controls can be imposed that would allow foreigners to sell securities but prevent them from exchanging the local currency they get for anything else, or would forbid them from removing sale proceeds from the country.
Or the government might simply tell foreigners they couldn’t sell …or could unofficially tell local brokers they could not accept a sell order from a foreigner or process a completed transaction.
Not good.
active managers vs. index funds/ETFs
Veteran investors in emerging markets generally understand that the battle of wits between buyer and seller can sometimes turn into a game of Whack-a-Mole, with them in the role of the mole. They cope either by staying completely away from the riskiest markets or holding only the safest names in small amounts. They meet redemptions by selling some of their holdings in larger, more stable markets if they’re caught in a no-liquidity market.
This is a plus and a minus. On the one hand, fund investors can get their money back. On the other, by rerouting selling from risky to more stable markets, meeting redemptions ends up creating a minor kind of contagion.
Index entities, on the other hand, have little discretion. They don’t have active managers to do selective selling. They don’t want active managers, either. What if the manager sells the wrong stuff and the fund/ETF underperforms, as a result?
ETF selling, which I’ve read has been quite heavy recently, exerts downward pressure on everything in the index–good or bad, sound country or not. This ends up being another, stronger kind of contagion.
The question I don’t know the answer to is what an emerging markets index fund/ETF does with illiquid securities that its mandate (to mirror a specific index) forces it to sell but for which it can find no buyers. My guess is that the firm that runs the index entity purchases the securities in question, after having a third party determine fair value. I don’t know, though.
Anyway, problems in a few emerging markets can quickly spread to the whole asset class.
what to do
At some point, I think the right thing to do will be to look for an experienced emerging markets manager with a good track record, who works in a strong no-load organization. Let him/her sort through the rubble for us. I don’t yet feel a strong urge to do so, however.
problems in emerging countries (i): economic
There has been a lot of hand wringing lately about emerging markets. Worries are two-fold: economic problems and stock/bond market problems. Today I’m going to write about the first, tomorrow the second.
Even when I was in school, there was a well-understood, coherent, all-encompassing theory of how a closed one-country system works economically. There’s nothing like that, even today, for a multi-country system with open trade, differing political philosophies and involving countries at various states of economic development.
I guess I’m saying that what follows is highly simplified, although I think it still gets across what the basic forces at play are.
an emerging country
Suppose the citizens of an emerging country, or the government for that matter, want to obtain goods made by another country. Let’s also say the seller won’t accept the buyer’s local currency but wants to be paid either in its own currency or in some global standard, like dollars, or euros or renminbi.
The buyer has several choices. It can:
–barter with the other country, avoiding the forex issue,
–sell domestic goods in international markets, obtain foreign currency that way and use it to buy the foreign goods,
–use foreign currency it has previously piled up somewhere,
–sell domestic assets, like farmland or mineral rights, to foreigners or
–borrow the foreign currency it needs.
If the country routinely generates enough foreign exchange to meet its needs (think: oil exporters), there’s no problem. It can buy all the foreign goods it wants. But that’s not normally the case. Emerging countries routinely run trade deficits (that is, they buy more stuff from foreigners than foreigners buy from them). To make up the difference, they borrow any extra foreign currency they require. [an aside: it’s also possible that the government of the country we’re talking about runs a budget deficit, meaning it spends more than it takes in. That’s also a problem, but it’s not what we’re talking about here.)
In economic boom times, investors tend not to worry too much about how and when they’re going to be repaid. (In fact, a generation ago international banks deliberately made loans to emerging countries that they knew could not be repaid. The banks figured they’d collect big fees when the loans were restructured. The possibility of default never entered their heads.)
In leaner times, investors look more carefully. They make a (crucial) distinction between borrowing that pays for factories that will manufacture goods for local use or export, and borrowing that pays for purchases that produce no economic return (think: flat screen TVs, gold jewelry or military gear). Building factories that will generate foreign exchange in a year or two is ok. Borrowing to buy consumer items isn’t.
Lenders may initially be willing to make loans that are payable in local currency. As/when the country begins to have a chronic trade deficit, lenders are no longer willing to do so They shift to loans repayable in dollars…, which makes the foreign currency problem worse.
In cases where lenders see the probability getting their money back declining, new lending dries up. The local currency begins to weaken. The government has to raise interest rates–this supports the local currency and cuts into demand for foreign goods by slowing overall economic activity. This is all toxic stuff politically. Sometimes (think: Argentina) local governments find any form of austerity to be impossible.
In my experience locals sense the beginning of a downward spiral long before the international investing community does. Capital flight begins. This makes the situation worse.
loose worldwide money policy
One of the side effects of qualitative easing in the US + Abenomics in Japan + Chinese efforts to promote the renminbi as a world currency has been to flood the world with money. A lot of that has found its way into sketchy emerging countries that are economically unstable and on the verge of a currency crisis. It appears many yield-chasing investors were unaware of the risks they were taking. The presence of relatively high yields was all they saw. Others were playing the greater-fool theory, figuring they could sell before the music stopped.
When the Fed began to talk about an end to tapering, the latter group knew the game was up and began not only to cease new lending to,but also to extract their money from, what has since become known as the Fragile Five. That has led to weakening currencies, lower securities prices and a higher cost of lending in these countries.
why it’s good that China’s growth is slowing
One of the reasons for the current selloff in world equity markets is worry that China’s growth is slowing.
I think these fears are based on a misunderstanding of what’s going on in the Middle Kingdom.
As I see it, a reformist regime in Beijing is trying to break a recurring cycle of wasteful residential/commercial construction and creation of inefficient, low value-added, highly polluting basic industry that has marked many regions of the country.
The problem:
1. Every local or regional government official is a member of the Communist Party. Officials get promoted if the areas they’re in charge of show full employment and rising GDP.
The easiest way to achieve both is to support the building of large housing complexes and of (inefficient but) labor-intensive plants that produce, say, steel or chemicals. The fact that, once up, the housing tracts may remain empty, or that there are already too many such plants spouting pollution in China (and that, in consequence, they have little chance to make profits) is a problem for another day. Maybe the officials in question will already be promoted to higher office and be gone before anyone works this out.
2. The easiest way to get funding for dubious projects is to call on the head of the local state-owned bank. That person is also a Party official who, like the mayor or governor, is judged on producing growth. For the banker, it’s loan growth. Even if he has doubts, it’s very hard to say no to a higher-ranking Party member. So the bank ends up facilitating the building of these white elephants, while also piling up a bunch of toxic loans that will eventually undermine its balance sheet.
3. Banks have already gotten repeated orders from Beijing not to do this kind of dodgy lending. But “the mountains are high and the emperor is far away,” as the saying goes. So banks acquiesce to local pressure. They also appear to be using the time-honored ploy of financial institutions around the world of creating and funding non-bank entities that will actually carry out lending that’s forbidden. So off-balance-sheet liabilities are piling up.
4. There’s also an issue of corruption, of lavish gifts given by the project sponsors to Party officials to get the worthless projects rolling. Beijing has been talking for at least a half-decade about how seeing Party members enrich themselves through their control of economic development undermines the legitimacy of the Party and can lead to social unrest (which is perennially the Party’s greatest fear). The current regime appears to be taking this issue very seriously and to be cracking down on corruption in a way that’s very visible in the falloff in sales growth for Western luxury goods makers.
my take
Breaking the tendency of local/regional governments to create “phantom” GDP will take time. And, to the degree it’s successful, it will result in GDP growth that is not only lower, but unpredictably so.
I think investors in China-related equities will be relatively unaffected by lack of predictability and modest weakness in overall GDP growth. Just avoid real estate and basic industry for now.
sketching out long-term stock market themes (ii)
competition
1. Some (not many) domestic-oriented US companies are mentally living in a past that no longer exists, making them particularly vulnerable to competition.
How so?
WWII had two immediate effects on US industrial companies: their domestic installations were the only plant and equipment still left standing after the conflict in Europe and Japan, so they had eager customers, no matter what the quality of their output; and a generation of leaders abroad, grateful for American assistance in rebuilding, gave preferential treatment to American firms.
This wasn’t “normal,” and it’s no longer the case. Those leaders are long-since retired. When China thinks of the US, it thinks of the Boxer Rebellion, not WWII.
2a. The Internet has destroyed many barriers to entry, or “moats,” as the academics like to say.
–It allows large, established firms to control far-flung manufacturing and distribution networks remotely.
–It allows them to stitch these networks together out of both owned and third-party pieces, so they can keep high value-added pieces in-house and farm out the rest.
–It allows fledgling firms to mount low-cost social media product awareness campaigns, to open their own online storefronts and also to distribute through third-parties like Amazon.
As a result, the embedded value of many years of past advertising campaigns no longer sets the bar for creating public interest in a new product. Slowly building your own bricks-and-mortar retail presence, your own warehouses and your own fleet of delivery trucks isn’t needed to get wares into the hands of customers, either. And you don’t need to lay out tons of your own capital to build an effective supply chain.
2b. A recent article in the Financial Times points out that the US has about 5x the mall space per capita as the UK, 6x as much as in Japan and 8x as much as in Germany. To the extent that retailers have signed long-term leases to rent this space, it can act as a ball and chain around a firm’s ankles, as online replaces bricks-and-mortar.
3. Emerging economies understand that the ticket to entering the developed world is technology transfer. That requires offering multinationals a low-cost workforce and state-of-the-art plants to induce them to open up in their country so locals can learn how to work in, and ultimately run, a manufacturing business. This means a constant stream of new manufacturing plant coming into existence, undercutting the value of existing capacity (developing governments are looking for employment and technical education, not profits). Developed countries’ only effective response is continual modernization and innovation.
4. Hydraulic fracturing (“fracking”) is lowering the cost of producing natural gas and oil. So far, fracking is happening mostly in North America. So it’s principally a boon to manufacturers here, like chemical companies, that use hydrocarbons as feedstocks. It’s also putting more money into the hands of American consumers, who (thanks to a uniquely misguided government energy policy in the US) use double the oil and gas per capita of anyone else.
We’re already seeing foreigners building new energy-intensive plants in the US to try to level the paying field. Great for the balance of trade and for domestic employment.
The bottom line: this is no longer a rest-on-your-laurels world for established companies. For investors, this means the odds on backing younger “disruptive” competitors are better today than they have historically been.