After passing much of 2008 standing thankfully on the sidelines, we believe that with current valuations, opportunities have returned for putting capital back into long-term positions in emerging markets. In fact, we believe that emerging markets will recover faster and outperform developed markets over the long term.
In our December 2007 edition of Without Borders we wrote:
“So much money has been sloshing around the globe in search of an "above average" return that even risky assets have been bid up tremendously. At this stage, however, with new holes in the financial dike showing themselves almost weekly – more holes, we suspect, than officialdom has fingers – the money flows are building toward a reversal. This will hammer the emerging markets the hardest because, historically, in times of crisis, capital packs up its bags and goes home. When that happens, shares of good companies get sold at the falling bid simply because the seller must get liquid, whether to calm his fears or to cover his losses elsewhere. Asset prices become screaming passengers strapped into a luge ride.
“This creates opportunity, of course. Even though the economies of all the most prospective emerging-market countries are strong enough to weather any likely storm, their financial systems aren’t. This is emphatically true in India, China, Brazil, and other fast-track economies. Even so, when foreign financial capital has fled, the physical and human capital will remain, it will still be valuable, and good investments will be cheap in the extreme. But the opportunity won’t be available for everyone – just the investors who’ve been patient.”
Then in April 2008, we gave our presentation on “Bottom Fishing for Stocks in Emerging Markets,” during which we highlighted that the single most important factor in emerging-market stock markets is capital flows. In the emerging markets, the time to invest is when capital has fled the country.
We know we disappointed the crowd when we said that there was not one emerging market we found attractively priced and that shorting in emerging markets is almost impossible, so our strongest recommendation was to do nothing.
It’s quite a skill to do nothing and do nothing well. We sidelined ourselves and watched, staying away from emerging markets for most of 2008.
But now… finally, the catastrophic sell-off in global financial markets had the effect that we expected: there was a huge sucking sound coming from public equity and currency markets in Russia, Brazil, China, Taiwan, Malaysia, India, South Korea, Colombia, Chile, etc. Foreign institutional investors came face-to-face with the reality of lower risk tolerance and deleveraging and were forced to sell. Everything.
The ensuing flight to quality left emerging markets and their currencies decimated… but herein lies the opportunity. We just hope the IMF and World Bank will run out of money or leave them alone, thereby preventing the return to the boom/bust cycle of the 1990s.
Bullish long-term outlook
Remember, the sell-off in emerging-market equities, bonds, and currencies reflects a rush for the exit sparked by global deleveraging and a need to raise cash, rather than any change in the fundamentals. When the current turmoil subsides, we believe that emerging markets will fare better than developed markets and will outperform the latter over the long term. As such, we find that current valuations are solid entry points for putting our hard-earned capital into long-term positions. Consider:
* Emerging-market economies will prove resilient during this economic slowdown and may account for all of world economic growth in 2009 as developed markets slow to zero.
* Emerging economies are not nearly as dependent on consumer spending and almost not at all exposed to consumer credit. * Emerging markets by and large suffer neither the demographic imbalance nor the entitlement imbalance that plague the developed nations.
* Corporate and personal balance sheets in emerging markets are stronger than those in the developed markets.
* In many emerging markets (Brazil, most of South East Asia, India) as well as several African nations, domestic or regional demand is now more important than exports for GDP growth.
* Among stronger economies, high foreign-exchange reserves and lower foreign debt levels act as insurance against the global slowdown; reserves have grown six-fold to over $4 trillion over the last ten years.
* Over the past ten years, emerging-market companies have produced higher profits with lower (but not necessarily low) leverage, while profits expanded annually by double digits during the past ten years.
Cash Rich, Resource Rich
Compared to the late 1990s Asia crisis, the present situation is much more stable for emerging markets. While we expect current account surpluses to deteriorate given the global slowdown and recessionary pressures, emerging markets will face this challenging period with cash in their bank accounts.
The importance of this change cannot be overstated.
Much like individual households that stash away something for a rainy day, many emerging-market countries now have a greater reserve of wealth with which to buffer financial market headwinds. This gives them the option of taking fiscal stimulus measures to offset the effects of a developed-markets slowdown without having to go into debt. While we decry these neo-Keynesian actions as throwing water on an electrical fire, historically they have boosted share prices.
As part of their fiscal stimulus, we also expect to see higher infrastructure spending by countries with the financial muscle to do so. China, for example, which is projected to have more than 200 cities with populations exceeding one million people by 2025, up from just 23 in 2005, announced in early November 2008 a two-year infrastructure investment and stimulus package of up to 4 trillion yuan ($586 billion). While much of this stimulus will come in the form of strong-arming banks, there will be substantial cash injections in the Chinese economy, and they have the cash to do it: highways, railroads, and airports. The government hopes that this stimulus package will also encourage increased consumer consumption. All this is good news for raw-materials companies, one of which is an undervalued Chinese cement company that is a cornerstone of our portfolio. (Learn more about this company here.)
The turning point
Emerging markets will be the catalyst for global economic recovery, not the West. Like China, many emerging markets that have been saving for a rainy day have the cash and political will to spend on development projects that require raw materials. Others, like Chile and Angola, have the raw materials to sell. Even more so, a few countries like Brazil and Saudi Arabia have both. The economy will get jumpstarted with these countries initiating their own trade without the leadership or consumptive traditions of the Western world.
Perhaps even more pointedly, we foresee a highly inflationary environment over the next several years… all of the dollars with which President Obama will be flooding the world will have to find a home somewhere. This will more than likely spark another commodities boom, which is supported by the world’s ever-growing demographics, resource scarcity, and climate-change legislation.
As such, resource-rich emerging markets are going to find themselves being the future home to foreign investment capital again. Institutional capital will trickle, then gush into these markets as the world wakes up one day and finds oil and copper trading at twice their present levels.
Consequently, today’s emerging markets will be the net recipients of the future inflation that is being created by the West.
Capital Flow Conclusions
We have long said that capital flows are the most important indicator for emerging equity markets. Investor outflows in the second half of 2008 already equal one-third of the total inflows into emerging-market equity funds over the prior five years. This is a positive sign for contrarians looking for a bargain. There has been a bloodbath, and this is a buying signal.
We recognize that the ride will likely be bumpy. Fiscal stimulus, trillion-dollar deficits, and politicoramus bickering may cause a roller-coaster ride to the top… but the evidence strongly suggests that, once institutional funds finally realize that U.S. Treasuries are a fool’s bet, remaining capital will be on the hunt and flowing back into emerging markets. The window is open, and we are dedicating our efforts to finding the most undervalued companies with rock-solid management and balance sheets.
© 2009 Editors of Without Borders
Casey Research
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