Is buying emerging markets financial suicide?

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.

Such an observation is also supported by the structural shift of foreign directs investment flow. Presently, more than twice as much money flows into China than into the rest of Asia (ex-Japan) combined compared to the late 1980s when FDI's into China where far lower than into the rest of Asia.

Now, I do admit that this scenario of slow future export growth in Asia, together with the emergence of China as the leading manufacturer in the world is not particularly positive for most of Asia's economies. But remember that corporate profitability is another matter, altogether. Take for instance a Taiwanese or Japanese manufacturer. By shifting production into China, it badly damages the local economy as workers are laid off and factories closed. However, such a manufacturer can boost its own profits, as costs are reduced significantly and as it gains access to the domestic Mainland Chinese market.

So we see that there can be a diverging trend between the performance of the overall economy, which as a result of production shifts suffers, and individual companies' profitability. Just think of what would occur to Japan's economy if overnight every Japanese company decided to shift 25% of its manufacturing capacity to China but how these companies' profitability would at the same time improve.

Once again, I am stressing here that selectivity of one's investments will be in future the key to success in Asia. Unlike in the past, where Asia was largely in a 'win-win' type of environment, we will now have to increasingly deal with 'winners' as well as 'losers.'

Let me offer some thoughts. In China, increasingly, domestic manufacturers whose competitive position is improving will squeeze out foreign companies such as cellular phone manufacturers, which relied heavily selling their products into China. Also, as more and more foreign companies start to produce in China, its domestic economy will remain robust and lead to rising property prices in the long run.

In this respect, I believe that Shanghai properties are one of the most interesting investments at the present time. In India, I can see that the software industry will continue to grow. The Indian software industry will not only penetrate the domestic market but it will also gain market share from software providers in Europe and the US thanks to its cost advantages.

India's drug industry will also grow rapidly, since it will largely ignore foreign patent rights and over time develop more and more its own drugs. In Thailand, it is obvious that in the long run the manufacturing sector has little chance against Chinese manufacturers, but as China becomes more prosperous, Thailand's tourist industry will thrive on the back of zillions of Chinese visitors.

Similarly, natural resource producing sectors of countries such as Malaysia, Indonesia, Vietnam, and also Australia and New Zealand will do well as China may one day become the world's largest importer of commodities such as coffee, cocoa, copper, plywood, timber, grains, and meat.

At the same time China will expand its political clout in Asia and as a result will also become a capital exporter to Asian countries, which are of some strategic importance such as Myanmar, Cambodia, the entire Central Asian region and Far East Russia.

In fact, the Russian Far East could be for a while a major beneficiary of China's growth as it can supply China with all its resource wealth. (Asian opportunities aside, I incidentally believe that the Russian stock market has over the next two years the greatest up-side potential).

So we can see that while slower export growth rates and the emergence of China as the region's dominant economy will not be very good for overall economic growth rates in Asia, some sectors of its economy will benefit from China's rising prosperity.

And since Asian equities have under-performed the western markets so badly since 1990 and often sell for single digit P/Es with high and secure dividends, I remain confident that investments in selected sectors in the region is the right move. It is not akin to 'financial suicide', but a very timely shift from the developed western markets, which are likely to perform poorly for quite some time.