Sunday, January 10, 2016

Equities and the Emerging Market Curse

OK, I'm not an equity analyst, but as a non-professional (unprofessional?) investment blogger, I am entitled to my opinion. So here it is:

The most important factor in equity prices is the future growth of corporate earnings. Graph the long term S&P against corporate earnings and you get parallel lines (on a log scale). So, where is future earnings growth going to come from? Not from the developed world. The demographics of these areas, combined with their debt levels, make for a long period of slow growth in the US and very slow or zero growth in EC and Japan.

That leaves the emerging markets, BRICs and such. For most of the century, it looked like the ball had been passed to them. But it hasn't been organic total factor productivity growth for many years. Rather their growth was the result of capital inflows and movement of non-market peasants into the market economy. I remember talking with a portfolio manager of a major asset management company about four years ago. His working maxim, "you've got to put your money where the growth is. That's China." BTW, I also seem to remember a series of pieces from Goldman a few years ago that divided the world into stable and growth markets. The "growth" was EM.

What did the BRICs do with the inflows? Well a lot of it was stolen. Brazil is the poster child of this only because Brazil has a somewhat honest judiciary. Many of the countries that don't make the corruption news were as bad or worse. Much of the rest went to uneconomic or vanity projects (the skyscraper curse). And a lot went into an overcapacity of heavy industry. That's why we are where we are in the commodity space and the traditional manufacturing space.

But that's over now. The inflows have almost dried up; I'll bet that net of corruption they are about zero. Meanwhile:
- The demographics of EM are moving towards EC levels.
- There's no more developed market export market growth for the stuff they are able to produce (commodities and manufacturing).

So where's their growth going to come from? Ideally they should transition from a commodity/manufacturing model to a consumer goods/services model. The problem is that this is hard to do. With manufacturing, you only have to import the technology from in the West and add a few million impoverished peasants. Services are more culture-dependent. You have to develop the human capital within the context of your society. This is not a quick job. It will happen, but only slowly, and it may not need much help from the S&P 500.

What I'm trying to say is that multinational corporate profits are likely to grow only slowly over the long term, maybe low single digits. With the P/E of the market at about average, this means overvaluation. And this is why any news from China has such a disproportionate effect on the market. It's the only source of growth left!

I've been almost out of the stock market for about a year now. Still hold a few special situations, but not overall beta. Recently I have started nibbling on high yield and senior loans via discounted closed end funds. I suspect that will continue for most of 2016.

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