Ugly future vs good chance of turnaround

The bigger fire is ahead of us, not behind us, reads the ominous message of John Mauldin and Jonathan Tepper in Endgame: The end of the debt supercycle and how it changes everything ( www.wiley.com ).

Describing the crisis to come as ‘global endgame,' the authors foresee that for some countries, the end will mean default, while for others it could mean inflation, devaluation and so on. “Some countries have a fairly ugly future, while others still have a good chance of turning things around.”

Emerging markets

Exploring the characteristics that will drive outperformance in emerging markets, the authors identify the following: Generous liquidity, that is, rapid monetary expansion; positive demographics; declining real interest rates; underleveraged consumer; and banking sector with low loans-to-GDP ratio. “The main countries that satisfy these requirements are Turkey, Malaysia, India, Indonesia, and Brazil.”

Yet, it can be sobering to learn that emerging markets, which are expected to double or triple over the next few years, are extremely small as a percentage of total global market capitalisation. Individually, the emerging markets are less than 0.5 per cent of total world capitalisation, the authors note.

A telling chart in the book has a line up of bars showing the total market caps of some of these markets alongside the market caps of a few well-known blue chip stocks. “Microsoft has a bigger market cap than all of Indonesia, General Electric and Wells Fargo have market caps almost double that of all of the Philippines, Monsanto and Time Warner have bigger market caps than all of Vietnam and Pakistan, and GAP Inc's market cap is almost double that of Sri Lanka.”

China outlook

In the case of China, what the authors find to be significant is the regime of tight capital controls that keep a lid on overseas speculation. If these controls were relaxed, however, and the currency allowed to freely fluctuate, then all bets are off as to the effect on Chinese markets, they observe. “This would be no different from Japan in the 1980s, when the capital accounts were opened up and the yen was allowed to float. Indeed, many if not all of the bubbles that have occurred since the Dutch Tulip Mania in the seventeenth century have been precipitated by a combination of financial liberalisation and innovation.”

On a different note, talking about the large Chinese investments in US debt, ‘an odd form of vendor financing,' and about what foreigners think of the US fiscal situation, the authors cite a report by the Telegraph of the UK on the China visit by the US Treasury Secretary, Mr Timothy Geithner, thus: “Speaking at Peking University, Mr Geithner said: ‘Chinese assets are very safe.' The comment provoked loud laughter from the audience of students.”

Investment insights

A major investment theme in the coming decade is likely to be the emerging markets because, as the authors predict, these markets will be overwhelmed by liquidity from developed markets, almost comparable to ‘putting a fire hose through a straw.' Fretting that most investors weight the American and European markets too heavily due to home bias in investing, the authors also see a behaviour that is no different from ‘a drunk searching for his keys under the lamppost.' They rue that most investors in emerging markets do not look for the right data and merely decide to either take risk and invest or reduce risk and withdraw funds.

In the authors' view, at the bottom of the next US recession, emerging market countries could see their economies and stock markets finally decouple from the US, and at that point they could become the trade of the decade. “We suggest that investors use the time to find specific stocks and not just country ETFs, or find someone who can do that work for you. Fortunes can be made if you do your homework.”

Recommended read for a global perspective on finance.

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