There’s a story from the dotcom days about an unfashionably bearish strategist visiting a fund manager with a heavy tech slant to his portfolio.
The strategist sets out why he’s convinced the market has gone mad, expecting to be ignored as usual.
But this time, the manager cracks. “Stop, stop”, he begs, seemingly on the verge of tears. “You’re right. It’s insane. But what can I do?
“If I sell tech and it goes on for just six months more, all our investors will pull their money out. We’ll be bust and I’ll be unemployed. I can’t take the risk.”
This tale crops up so often, and is attributed to so many different people and places, that it’s tempting to view it as an urban legend. But in fact, I suspect that it simply has happened over and over again, because it’s just an extreme example of the problem with every investment.
I can sympathise with both the strategist and the fund manager. There’s a time to think like each – and this is particularly true if you’re investing in emerging markets.
Reasons to worry about the BRICs
Last week, I met derivatives expert Satyajit Das to talk about his new book: Extreme Money, which I’ll be reviewing soon in MoneyWeek magazine. Among many other topics, we talked about emerging markets.
Das is fairly pessimistic on the outlook for the global economy as we try to sort out the largest financial sector crisis in history. And he sees much to be concerned about in emerging markets.
For example, as the US and Europe stagnate, China will see a lot of export demand fall away. If it tries to compensate for this by continually increasing investment, the return it gets on each round of investment will decline each time (returns on many state-directed investment projects are already poor).
At the same time, the country’s demographics and the system’s implicit social contract – the communist party gets to rule unchallenged, as long as the people get wealthier – argues for the need to keep growth as high as possible now.
That’s a big enough headache for policymakers. On top of that you have issues such as dealing with trade tensions, and handling US$2trn of currency reserves that are in a sense worthless because they can’t really be sold even while the US debases the dollar.
India has the opposite problem. It doesn’t depend on exports, but international financing and foreign direct investment is very important. If this dries up, anyone who has got used to easier credit and abundant liquidity will be in trouble.
Meanwhile, the government hasn’t succeeded in developing infrastructure and building up the country in the way that China has. Arguably, India might actually be in a worse position than China to deal with future crises.
What about Russia? It’s essentially an oil company, dependent on high demand for crude, driven by China and other emerging markets. If that goes away, Russia doesn’t have much.
Brazil? Many people would say commodities, but much of what’s been driving the Brazilian boom is a surge in domestic credit. As the chart below from UBS shows, while bank credit (the blue line) doesn’t look too dramatic, once you factor in corporate bonds and other lending, Brazil has seen a significant rise in debt in the last few years.
There are major potential problems for southeast Asia and elsewhere too. But it’s enough just be aware that the four giants of the emerging world on whom so much hope is placed are certainly as flawed as any other economy. They’re just growing faster – and growth can hide a multitude of sins.
Every boom turns to bust
Even though I write about investing in emerging markets, I agree with Das’ concerns wholeheartedly. There are plenty of risks, imbalances and structural problems in every emerging economy I can think of. And the next decade will not be kind to countries that make mistakes.
Southeast Asia was able to recover relatively quickly from the 1997-1998 Asian crisis because export demand from the US remained robust, and the collapse of their currency pegs made these countries very competitive. The same support is not available today.
Of course, there doesn’t have to be a crisis. Handled correctly, most of these risks are manageable. For example, China can try to deploy future investment in a way that doesn’t produce a high return, but helps to resolve social tensions (eg, by investing in health, rural development, the environment, and improving the rule of law). This might mean the country feels less like a boomtown, but becomes a more stable economy.
Are more optimistic scenarios like this probable? As a general rule, I have little faith in the ability of governments and regulators to avoid crises. After all, the answer to resolving our current problems was not to get into this mess in the first place – something that was at least partly obvious to anyone paying attention since the early 2000s.
So while I think that by luck or design, some emerging markets may avoid the worst, I have little doubt that many of the current growth stories will end in a crisis.
The investor’s dilemma
This is the strategist’s problem from the story at the start. If he’s of a sufficiently bearish bent and is familiar with history, he knows that the odds are that it will not end well.
But the manager doesn’t have the same luxury. Their question is: how soon will the bust come?
And the manager’s problem is closer to how we act as investors.
We’re not talking about the dotcom problem of whether you can hold on for another quarter when the market is obviously mad. By then, you should be bailing out.
Instead, let’s consider the US at the start of the 1990s. The pessimist could have pointed to debt levels, which had exploded over the past decade, from around 150% of GDP to around 250% of GDP. There was no way this could continue indefinitely.
Meanwhile, the stock market looked fairly valued and perhaps even a bit expensive on long-run measures such as ‘equity q’ and the cyclically adjusted cyclically-adjusted p/e (CAPE) ratio. This was clearly not a great time to be in stocks.
Of course, over the next two decades, the debt problem continued to grow, hitting around 350% of GDP before everything came tumbling down. Stocks had an up-and-down ride through the dotcom bubble.
But the S&P went from around 400 in the early 1990s to over 1,500 at the peak in 2008. And you didn’t need to participate in the dotcom insanity to derive some benefit from that bull market. Buying something as ‘boring’ as Colgate Palmolive would still have produced very good returns.
So I’d applaud the strategist for spotting the risks early. But I would not be happy with an investment manager who had kept me in cash and failed to realise any gains from the market over 20 years, based on that same strategy.
Every major bull market ends in a bubble and then a bust. Successful investing isn’t just about spotting the bubble. It has to include working out how much you want to participate in that bubble and how you will avoid the worst of the bust.
Buy the value, sell the bubble
Now, very obviously this is not the same environment as the 1990s. The next few years are going to be very difficult. Volatility will be high and crises will escalate easily.
Nonetheless, many emerging markets are doing well and should continue to do so, even if growth is slower this year. And with growth and optimism set to be scarce in the years ahead, countries that offer it will be seen as attractive investments.
This may well end badly. Indeed, the more foreign money rushes into emerging markets, the more likely a nasty outcome will be. But whether that happens in two years, five years, ten years or not at all is impossible to say – only that present valuations don’t suggest we’re in a bubble, as I’ve noted already.
And there are only a few cases – such as Turkey – where there are obvious immediate macroeconomic risks that don’t yet seem to be reflected in prices. Vietnam, for example, is still struggling with inflation and overheating – but looks very cheap.
So what do you do to get some benefit from this, while not being reckless about the very real risks? The first thing is to be diversified. Obviously, emerging markets should not be the only thing in your portfolio.
Buy better quality firms, rather than second-rate peers, even if they look more expensive. Higher quality stocks perform well over the long run, while having better survival prospects when it all goes wrong. You might still choose to sell them when you think a crisis is imminent – but you probably don’t need to worry about them going bust. Take a long-term view. If you buy high quality investments and you have a ten-year horizon, then a crisis that lasts even a couple of years is much less of a concern.
Hold some cash and near-cash (shorter-term liquid bonds). Yields are low, but it gives you options. You don’t have to be a forced seller at the wrong time during a sell-off. And you have funds to invest when a crisis hits, which is when the opportunities are best.
Finally, you need to balance your inner strategist with your inner manager. And the only way to do this is by investing where justified by value and hoping that it turns into a bubble.
Don’t invest into a bubble in the hope that it will become a bigger bubble. That’s the difference between buying the S&P in March 1990 and March 2000. The former was the time to trust the manager, the latter the time to trust the strategist. It’s easier said than done – but it’s what every emerging market investor needs to bear in mind during the much tougher decades we face.