Is buying emerging markets financial suicide? (page 1 of 2)

What our friend meant is that with the US already in, or about to go into, a recession, then investments in emerging markets can not be a rewarding proposition. And indeed US industrial production has been now declining for eight months in a row and US equities have fallen.

After all emerging markets do depend to some extent depend on exports to the US and also on foreign capital flows. Still I maintain an optimistic stance toward emerging stock markets for the following reasons.

As regular readers of this column will know, I have been forecasting a profit deflation and recession in the US for over a year. This is largely based on the fact that the NASDAQ bubble had burst in March 2000 and that the high tech capital spending boom and credit bubble, which had driven the economy since 1998, would turn into a colossal bust.

As a result, all our comments about equities in the last twelve months have been negative. But, even for a hard-core bear, there is a price at which some buying can be justified. After all, most markets will discount future bad news well in advance. Thus, in the case of the Asian emerging markets, which are today still down by around 80% from their highs prior to the Asian crisis, I feel that a lot of bad news is already in the price of many 'selected equities'.

I am using here the terms 'selected equities', because I feel that the next bull market in Asia will be quite different from what we experienced prior to the Asian crisis.

Let us quickly analyze Asia's economic future in broad strokes and compare it at the same time to the 'golden age' for Asian stocks between 1985 and 1990, during which many Asian markets rose between 10 and 20 fold. Unlike in the late 1980s, future growth in Asia will be less export driven than in the past.

In the 1980s, exports from Asia started from a relatively low base, thus it was easier for exports to grow at as much as 35% per annum than now, that they make up for more than 30% of global exports. In addition, recessionary periods in the world usually lead to growing protectionist sentiment, which may dampen world trade somewhat in the years to come.

Thus, at very best, I would expect Asian exports to grow at about 5% to 10% per annum in future. However, in a weak global economic environment exports are likely to remain flat or even decline. Then, we also have to consider the growing presence of China and its economic impact on the rest of Asia as well as the world.

Not only has China become a mighty competitor for other emerging economies in the developed countries' import markets, but it also attracts an ever-increasing share of foreign direct investments, which flow into emerging economies. In the case of the US, imports from China as a percentage of total imports have grown from less than 1% in 1985 to 15.5% now, while Asia's exports (ex Japan) have been declining in recent years to just 6%.

Therefore, under any circumstances, either strong or weak global economic growth, investors should not buy emerging markets, because of future export growth, because with the exception of China, the outlook for exports is not particularly bright, as just explained.

This would particularly apply to countries like Japan, South Korea, Taiwan and Malaysia whose electronic and appliance industries can only suffer in the long run from China's growing economic prowess. Don't forget that in China labor costs are about 6% of what they are in South Korea and Taiwan and about 3% of Japanese manufacturing wages! Therefore, as more and more manufacturing shifts into China, the economic outlook for the traditional export tigers of Asia such as Japan, Taiwan, South Korea, Singapore and Malaysia is simply not terribly exciting.