Financial Times January9th 2012
It wasn’t supposed to happen this way. The biggest surprise for equity investors in 2011 was not the weakness of the crisis-ravaged European markets, but the carnage in the stock markets of the emerging economies. Amazingly the BRICs (Brazil, Russia, India and China) did worse than the PIIGS (Portugal, Italy, Ireland, Greece and Spain.) As a group they were down 26% in US dollar terms, versus a decline of 23% for the bad boys of the euro-zone.
While the developed economies have been struggling to generate any growth momentum, the emerging economies have had the opposite problem. Super-easy monetary and fiscal policy has led to real estate bubbles, capacity constraints and labour shortages. In 2011 governments moved to quell the inflationary presssures, even at the cost of stock market sell-offs and weaker growth.
Now that the effects of the tightening are increasingly visible, relaxation of policy cannot be far away. In a conventional cycle, this would mark the end of the bear phase and usher in the next emerging markets boom. However, there are reasons to believe that this is not a conventional cycle. The golden age of emerging market investment may already be over.
The first point is that re-inflating burst bubbles is easier said than done. The Chinese stock market is an example. When the Shanghai Composite Index peaked at 6000 in 2007, it was valued at a price book ratio of seven times, richer than the Nikkei Index in 1989 and the Nasdaq in 2000. Despite the unprecedented credit boom subsequently unleashed by Beijing, stock prices managed little more than a dead cat bounce. The Shanghai Index rose to barely half its former high and then tamely relinquished almost all the gains.
The de-bubbling of Chinese equity valuations has run a long way now, but the deflation of major city real estate from nosebleed valuations is at an earlier stage. This has potential to inflict damage on the economy as a whole and perhaps hasten the end of the investment-driven growth model. If China follows the Japanese template of the late 1960s and early 1970s, the downshift from double digit GDP growth will be abrupt , not gradual, and accompanied by a surge in real wages that will crush profit margins.
In the other major emerging economies, the equity market and real estate bubbles have been simultaneous rather than, as with China, consecutive. At first glance forward PE multiples look reasonable, but Shiller PERs – which use ten year averages of earnings – suggest that valuations in, for example, India and Indonesia, are still lofty by historical standards.
A second cause for caution is political and governance risk. The China Reverse Takeover Index, an index of 73 Chinese companies that have backdoor listings on US exchanges, trades on a historical PER of less that 4X. The low valuation reflects unease triggered by China Forestry and other debacles. A wider loss of confidence could lead to entire markets suffering similar deratings.
The third point is the supply-and-demand balance for equity itself. As a thought-provoking report from McKinsey points out, the world faces a cumulative shortfall in demand for equities relative to supply of some twelve trillion dollars over the current decade. This “equity gap” is almost entirely a phenomenon of the emerging world, which will experience a cascade of equity issuance to finance future growth, but lacks the indigenous equity capital to absorb it.
The notion that investors in the mature economies will automatically gravitate to the high-growth of the emerging world owes more to marketing than empirical research. Credible academic studies (such as by Ritter of the University of Florida and Dimson, Marsh and Staunton of the London Business School) indicate that the relationship between economic growth and stock market returns is, if anything, mildly negative. The equity gap helps to explain why this should be so. Rapid growth does not benefit existing shareholders if it requires equally rapid expansion of the capital base. Companies that can capture new opportunities by investing from cashflow are a different proposition. It may be that the multinationals of the developed world offer the best way to capitalize from emerging economy growth.
After the Asian crisis of the late 1990s, the stock markets of the emerging world were cheap and under-owned and their currencies were super-competitive. The turbo-charged ride of the past decade has left them over-owned and bubbly, while their competitive advantage has been eroded by inflation and currency appreciation.
It will take another crisis before they become as compelling again.