Monday, August 1, 2011

Emerging Markets—A Safe Bet or Not?

The case for investing in emerging economies—stocks, bonds, and currencies—has seemed solid.  Ever since Goldman Sachs economist Jim O’Neill coined the term BRICs (Brazil, Russia, India, and China) a decade ago, these four leading emerging economies and their markets have shown rapid growth and investor acceptance.

As the largest developed economies (the U.S., Europe, and Japan) struggle, their political systems seem gridlocked as they face unpalatable fiscal and demographic realities.  The BRICs and other leading emerging countries, however, have much lower debts and faster growth prospects.  Average sovereign debt is about 40% of GDP versus about 100% in developed countries.  The BRICs have more than $4 trillion in currency reserves as well, so the ability to withstand problems would seem much better than in previous business cycles.  The long-term conceptual case for their currencies, bonds, and stocks still seems compelling.

But now might not be the time to make major allocations to these markets.  The rapid economic growth in recent years was accompanied by a surge in credit issuance.  As with the U.S. housing and credit bubble, credit growth in the BRICs in particular has become excessive.  Monetary authorities have tried to restrain such credit growth as evidence of bad loans is mounting.

A credit-induced economic slowdown is not likely priced into the currencies and securities of emerging market countries.  It seems prudent to be very selective in making purchases of emerging market stocks and bonds.  In addition, several of the currencies—Brazil notably—are historically quite overvalued relative to the U.S. dollar in terms of relative purchasing power.  Gains in the stocks or bonds of emerging markets could be offset by currency losses if the U.S. dollar rises in price relative to emerging market currencies.  After large gains already in these markets, one should exercise caution at current levels.

Steve Lehman

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