One of the most important investment concepts that I ever learned is the credit cycle. The credit cycle is like the tide. It’s predictable and it’s powerful. And you can’t afford to ignore it.
In the UK, we’re near the end of a credit cycle. After years of enjoying cheap debt, we are now caught in a dangerous down-cycle. And it has some pretty grim implications for a whole host of assets – from houses to stocks.
It’s a different story in emerging markets. Their credit cycle isn’t synchronised with ours. That’s why I’ve been arguing that now could prove a good time to diversify into these markets. Today I’ll explain how the tides are rising for emerging markets. And I’d like to show you an amazingly low cost way that you could benefit.
Never swim against the tide
Most investment pros ignore, or don’t understand credit cycles. The great exception is the Austrian school of economics. The ‘Austrians’ are a faction of economists whose views are gradually working their way into the mainstream. The Austrians tell us that financial markets are cyclical and the cycles are caused by banks and their lending practices.
Let’s put it in context for the UK.
Basically, we’re near the end of a cycle just now. If you cast your mind back to the early nineties, you may remember the cycle kicking off. First, banks and people were fearful as we came out of recession. People were unwilling to borrow, which was as well because lenders were unwilling to lend.
I remember looking at buying student accommodation in Canterbury in 1995. Boy, there were some bargains back in those days. But banks were cautious and so were borrowers. The memory of the negative equity saga from the previous cycle was fresh in people’s minds.
But starting from a low base, assets started to go up, both the stock market and property market. Banks and borrowers gradually got more bullish; lending went up and, bit by bit, caution gave way to greed.
Equity in housing and stocks rose as the banks pumped more and more money into the economy. The up-cycle didn’t turn until the sub-prime debacle hit the US housing market.
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Suddenly bankers got real: the crushing down-leg of the cycle came in 2007 as Northern Rock got singled out as a bank no other banks wanted to lend to. Credit (loans) was well and truly shrinking. Banks have been in ‘cautious mode’ ever since.
Emerging markets, on the other hand, are at a very different stage of the cycle. The late nineties saw a crash in the credit markets of Asia and Russia, which left many businesses unwilling or unable to borrow.
So as most of the West got stuck into the furious upswing in the credit cycle, emerging markets remained more cautious. They had no choice, nobody wanted to lend to them.
That’s why I’m still happy to play emerging markets. Of course, they’ll get buffeted by waves from the West, but as their banking industry continues to grow, I reckon there are some years left of their credit upswing.
Getting in has never been easier
Last week I mentioned two ways to get exposure to EM. You can use an investment trust, or, if you want to take on a bit more risk for potential reward, you can buy individual stocks – though many trade on much higher multiples than those in the West.
But exchange traded funds (ETFs) are probably the cheapest way in. ETFs basically aim to track an index. So in the UK, you could buy a FTSE 100 ETF if you want your investment to follow the ups and downs of the FTSE 100 (and you’ll get the dividends too).
For emerging markets, the index is the MSCI Emerging Markets index. This index covers 23 emerging market indices, so by buying this one stock, you’ll get exposure to all of these 23 countries. It’s like owning a tiny slice of every stock in EM.
And what’s most amazing is that this service is very reasonably priced. The Deutsche Bank EM ETF (LSE: XMEM) charges a management fee of just 0.65% a year. Compare that to unit trusts that typically charge up to 6% upfront and then around 1.5% a year and you’ll probably agree this really is a cheap way to get in…
As you buy the stock through your normal stockbroker, the only other fee you’ll pay is the market maker spread (usually very small) and your normal broker fee (there’s no stamp duty on ETFs).
As you can see from the table, the ETF has slightly underperformed the market in each of the last three years. That’s because the managers of the fund take their fees directly from the fund. The fund pays a dividend of around 2.2%, which is worth having in this world of negligible savings rates.
You can see from the figures that 2009 was a great year for emerging markets as they bounced back in the post-financial crisis recovery. Obviously emerging markets are correlated to Western markets. But at least the fund is in positive territory this year (unlike the FTSE).
The fund is traded in sterling, but obviously there’s a currency risk here, as the fund’s investments are ultimately in many different currencies across the emerging world. But rather than being a hindrance, I reckon currency is going to provide an extra fillip for emerging markets as these economies gradually catch up to the West and their currencies strengthen.
So that’s it for emerging markets. Three exciting ways to get exposure, all of them eligible for your SIPP or ISA.
• This article was first published in the free investment email The Right side. Sign up to The Right Side here.
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