If you are the type who likes to have something financial to worry about, I think it is fair to say that August has been good to you.
There has been the market’s irritable acceptance that China both has a major debt problem and is no longer to be relied on for growth. There has been the stunning collapse of some emerging markets currencies (the Indian rupee had its worst day against the dollar in 18 years last week). There have been the falls across the board in emerging equity and bond markets as well.
There have also been predictable signs that UK investors don’t entirely trust Mark Carney – he keeps telling us that his forward guidance is intended to keep interest rates down, but market rates still insist on going up. There are also signs of slowdown in the US economy.
Housebuilding stocks – something of a barometer for this kind of thing, are down 25% from their peaks – and in official bear-market territory. There is the US debt ceiling – politicians in America haven’t got long before they need to make a new deal on national spending and saving – again. And of course, there has been the sharp rise in the price of oil in reaction to the nasty geopolitical risks knocking around Syria.
You can trace most of these problems one way or another back to the same things – easy money, and the end (or not) of easy money. Take emerging markets. If anyone had asked a financial expert to guess, at the turn of the decade where they would make the most money in equities over the coming three years, they would, I think, have said Brazil or China, or perhaps somewhere in the frontier markets. Very few of them would have looked closer to home, and very few of them would have been right.
Look at the sectors that have performed the best globally and they are all firmly in the developed world. Over a five-year period, it is Japanese, American, European and UK smaller companies alongside technology and telecoms. Over the past three years, and even the past year, the list is pretty much the same. The real money has been made not in emerging markets but here, at home.
Note that the UK-based small-cap Diverse Income Trust I suggested here in November last year, has risen over 40% in the past 12 months, while most emerging markets funds have been lucky to offer up 5-10%, and the few funds focusing only on the Brics (Brazil, Russia, India and China) have all lost money in the last year.
What’s gone wrong? There is a simple answer as given by Société Générale’s Albert Edwards: the great emerging markets story has, he says, finally been exposed “as a pyramid of piffle”. And it isn’t really much more complicated than that: very low interest rates around the world have made debt cheap everywhere – not just in the quantitative easing-crazy countries. That sent a flood of money the emerging markets’ way and set them off on a debt binge that, in the short term at least, made their economies look remarkably healthy, and their bond markets the place to be.
However, now, as global interest rates turn back up again – and the flood of money that appeared with the quantitative easing (QE) bubble begins to pull back – investors that would once have gone anywhere for yield have started to look at fundamentals instead. It seems they don’t like what they see. QE might have papered over a lot of cracks, says Edwards, but in doing so, it has “allowed those cracks to become immeasurably deep crevasses”.
Regular readers of this column might not hold much in the way of emerging-market equities (every now and then I get something right), but if you do, should you sell? And if so, what do you buy?
The answer to the first question is no. It is rather too late to sell at this point. You are probably better off consoling yourself with the thought that you are now invested in relatively cheap markets for the long term and possibly buying more. That’s also the thing to think if you are invested in much of Europe.
However, one place you might sell as a result of the talk of the end of easy money is the US. It might look in better nick than the emerging markets, but it is hardly in the clear (rising real interest rates aren’t supposed to be good for equities), and its plus points are firmly reflected in its price: on a cyclically adjusted price/earnings ratio of about 21 times, the US market is now trading well above its long-term average levels (about 16 times).
To believe that it can really rise significantly from here, you have to believe that one of a few things will happen. Either interest rates will collapse again (unlikely in the short term); earnings will rise very fast from here (unlikely, given that profit margins are unusually high and outside the banks, earnings aren’t growing at all).
If neither of those things happen, anyone investing in the US is relying on a wave of new money arriving from somewhere – a round of money printing in Europe, perhaps, or a new round in the US as it imports deflation from suffering emerging markets. These things are entirely possible. But here’s the key: if global liquidity soars again, the emerging markets, starting from their current low levels, will surely do better than US stocks, starting from their current high levels.
If you are investing now, I suspect you’d be better off heading for the chaos of cheaper emerging markets than the seeming calm of the US. Better to buy markets at prices from which history suggests you will make money than at prices at which it almost guarantees you will lose money.
• This article was first published in the Financial Times.