In another resounding defeat for the forecasting community, the developed economies are leading a global economic recovery. It wasn’t supposed to happen this way. If there is a moral to all of this it is surely ‘never fall in love with an acronym’. As soon as the term BRIC entered the investing lexicon, trouble was in store. We were told to invest in emerging markets. Why? It seemed obvious at the time but, today, nobody can quite remember. The smaller equity markets are not exactly doing well and emerging market bonds and currencies are proving to be great destroyers of investors’ wealth.
It’s all about growth, or at least that is what we are told. That’s not an unreasonable position to take. But from an investing point of view, growth is rarely enough. In fact, the evidence is that simply investing in the stock markets of high growth economies, be they developed or emerging, just because they might grow quickly, is rarely a good idea. ‘’Invest in high growth economies’ seems to tattooed on the foreheads of many a stock market expert.
There are a few good rules of thumb when it comes to investing in stock markets. One is ‘don’t invest in countries and economies, stick to putting money into companies’. Like most simple rules, nobody pays much attention, despite the fact that there are abundant studies that suggest stock markets and GDP growth are, if anything, negatively correlated. During good growth years, equities do poorly, and vice versa.
It never ceases to amaze me how some people can be so personally offended by an empirical result, can get so upset by data. But it happens all the time. And the observation that weak GDP growth is often accompanied by strong stock markets often reduces market experts to gibbering wrecks. Once they recover from their trauma, those same experts then proceed as if nothing has happened: year in, year out they look for the next high growth story to invest in. Another good rule of thumb is ‘don’t invest in stories’.
The current capital flight from emerging markets is testament to the power of stories. Lots of investors bought the emerging market fable. Maybe they invested simply because they believed lots of other people were investing. Which, of course, is an abuse of the term investing: whatever that behaviour is, it cannot be described as based on sound, rational and conservative investing principles that have stood the test of time.
After the great financial crisis it became apparent that one or two of the world's great (I use the term loosely) investment banks had been playing both ends against the middle. Having spotted how nuts the housing and mortgage industry had become, products were invented that could be sold to clients who still believed in fairy stories. Those products were structured such that money was made when they were sold to those gullible clients and, subsequently, made even more money when the inevitable housing bust arrived. Michael Lewis wrote a great book about all of this called 'The Big Short', capturing the idea that some smart people made a lot of money 'shorting' the US housing market.
I’d be willing to bet that somebody is currently making a lot of money by being short the emerging market story. Michael Lewis may yet get to write another book, called something like ‘Short a BRIC’. Or maybe something catchier.
All of this would be relatively harmless if the flows of money were small. But they are large enough to have material impacts on the economies concerned, both on the way in and the way out. The sheer instability they create is a big problem. If the flows just consisted of cash belonging to hedge funds similar types we wouldn’t worry about them. But the money could possibly be yours and mine via our pension funds.
The pressure to invest in emerging markets over the last few years actually became such that some fund managers who didn’t buy into the fables lost business. It was a tough trend to fight. As with all investment booms, standing aside from the crowd can be a very uncomfortable place.
What now? Decent investment opportunities are now doubt beginning to pop up as a result of the emerging market bust. We can be assured that anyone who avails of them will both early and reviled. That’s the lot of those who try to be proper investors.
