Market Commentary
by Byron Wien

Don’t Give Up on Emerging Markets

At the beginning of the year, there were three potential areas of asset allocation that very few global portfolio managers wanted to consider seriously. As I traveled around the United States and elsewhere in the world, almost none of our clients wanted to hear about Japan, commodities or emerging markets. So far they have been wrong about commodities, which are a part of my radical asset allocation and have broken out of their trading range and headed higher. The standard of living continues to improve in the developing world, and one of the first things consumers do when their income increases is start to eat better. This means more meat and poultry where grains are used for feed as well as more consumption of grains by individuals. As a result of continuing growth in the developing world and flat to uneven agricultural production because of variable weather, prices for corn, wheat and soybeans have risen.

As for the other two areas of investor disinterest – Japan and emerging markets (both also in my radical asset allocation) – performance this year has been poor. Japan has been hurt by the increase in its sales tax from 5% to 8% in April as well as concern about a weakening Chinese economy. During March, I traveled to Chile and Colombia in Latin America. In April, I flew to Sydney and Melbourne in Australia and Kuala Lumpur, Singapore, Hong Kong, Beijing, Seoul and Tokyo in Asia. I talked with our clients and knowledgeable observers in these areas. While each region faces challenges, I believe the emerging markets generally present opportunities, but it is unclear when investors will start to appreciate them. Emerging markets have suffered for two reasons. The first is the belief that continued Federal Reserve tapering will cause interest rates in the United States to rise and the dollar to strengthen. This would be bad for those whose assets are in emerging market currencies. As a result there has been selling of equities in Asia and Latin America by local and global investors in spite of the fact that growth in those areas is considerably above that in the developed world.

The Russia/Ukraine situation has also had a broad influence in the emerging markets because it has highlighted the second reason for investor concern, the issue of political risk. The governments in many of these countries have only a tenuous hold on the power to influence the future course of economic growth. While Ukraine was never an area of investor interest, Russia’s action there caused concern throughout the developing world. It all started with Ukraine’s decision to move closer to the European Union. Vladimir Putin believes the break-up of the Soviet Union was the worst geopolitical catastrophe of the 20th century and he was not about to let Ukraine become a part of Europe. His actions led to the civil protest which resulted in a leadership change in Ukraine and the referendum in Crimea.

At this point, I do not believe Putin will move further toward strong military action, although there is much informed opinion on the other side. The new presence in Ukraine of armed gunmen in unmarked uniforms occupying government buildings replicates the situation in Crimea prior to the referendum. If Putin moves to take over Eastern Ukraine, I think it would be a strategic mistake for him. The response from the West would be a strong, and the sanctions already imposed have had a negative impact on Russia. He would be much better off waiting until later or moving very slowly now. Some of Putin’s closest advisors are for cooling the situation down, but Russia’s leader is both ambitious and unpredictable so one would be wrong to be complacent about the situation. Ukraine has revived concerns about political instability in the developing world hurting emerging market equities across the board.

During my trip I had an email exchange with my former Morgan Stanley colleague Steve Roach, who was in Asia discussing his book on the rebalancing of the Chinese economy. He and I have been in a dialog over the last few months about how much the Chinese economy will slow down if the consumer segment becomes the dominant driver of growth rather than credit-driven spending on state-owned enterprises and infrastructure. Steve believes the economy may not weaken as much as I fear because the service sector is becoming more important and each service sector percentage point of growth generates 30% more jobs than a point of growth in the manufacturing sector. He thinks growth will moderate very gradually and a considerable number of new jobs will still be created each year, reducing the likelihood of social unrest. One investor I discussed this with pointed out that it may be true that a percentage point of service sector growth produces more jobs than one in manufacturing, but many of them pay low wages and may not do a lot to increase the importance of the consumer in the overall economy.

In Singapore I had lunch with an old friend who has been successful at identifying unusual investment opportunities. He told me he believes that in the next several years North and South Korea will become one country. Most of the people of the North support the idea. So do those in the South – in part because they worry about the leadership in the North. The United States would like to see reunification; we are concerned about an unpredictable person with a nuclear weapon leading any country. And eventually the Chinese may think it is a good idea, but right now the Chinese like the fact that North Korea is a buffer between themselves and pro-Western South Korea. North Korea has considerable mineral resources and a merger of the two Koreas could be an important Asian investment opportunity.

Several discussions in Beijing yielded insights worth passing on. One investor was concerned about similarities between China now and Japan in the 1980s. During the 1980s there were numerous books written about how Japan was doing everything right, with robotics increasing productivity, very strong export growth and soaring real estate values. Japanese technology and consumer electronics stocks were U.S. stock market favorites back then. Suddenly it was all over and the Nikkei 225 declined 75%, and today it is trading at 35% of its peak level.

I pointed out some significant differences. China has a population ten times that of Japan. Its per capita income is one-tenth of that of the United States, and by improving its standard of living, China can hope to see its economy grow for a long time, especially if it is successful in shifting the components of growth toward the consumer. Also, China has a centralized government structure that can make decisions quickly and implement them without delay. This is in sharp contrast to the Japanese Diet, where the legislative process can drag on endlessly in a manner similar to the U.S. Congress.

What China must do is deal with its enormous pollution problem. My eyes burned and my throat was sore while I was in Beijing. It was worse on this trip than in previous years. There are reports that 280 million people do not have access to safe drinking water, resulting in high cancer rates. Ground pollution from industrial waste is also a serious problem. The pollution condition must be faced if China expects to have an increasingly important role in the world economy and geopolitics.

Another investor asked me what I would do to get Chinese consumers to spend more. I told him that improving the social safety net would help. The Chinese save for the after-school education of their children, healthcare and their retirement. If the government played a greater role in providing services in these areas, perhaps the Chinese would spend more time at the malls. That change is not likely to come quickly. Some investors are also concerned that the economy is slowing because of a lack of both domestic and export demand, which could reduce job creation, causing problems for the authoritarian government. Most Chinese would want to have a lot of cash on hand if that happened.

Everywhere I went in Asia investors were skeptical about their home markets, but Japan was extreme in this respect. Perhaps it was because the Nikkei 225 had a difficult first quarter and is down 14% in yen and 11% in dollars so far this year. In the longer term the aging population will cause the work force to peak in the next few years and this would make growth difficult. The country has initiated a guest worker program to mitigate this. Shinzo Abe’s first two arrows, fiscal and monetary expansion, have produced growth of 1.5% and inflation approaching 2%, achieving two of his objectives. The third arrow, regulatory reform and sustainable growth, requires legislative action and that will be harder to achieve.

Investors wondered why my asset allocation had a 5% position in Japan in the face of all of these problems. My response was Japan was clearly out of favor, few institutions held positions, the economy was finally growing and recent data was quite positive. Finally, there were a number of reasonably valued stocks available. I thought the risk of a further decline was low and there was an opportunity to make money from these levels if and when investors turned constructive. While monetary growth and bank loans have slowed recently, and this may have dampened the enthusiasm of some investors, I believe there is no chance that Prime Minister Abe will let the country slip back into a deflationary recession and another round of stimulus is ahead if it is needed.

In discussions with Asian investors, I addressed their geopolitical concerns, which focused on Russia/Ukraine, Israel/Palestine, the Iran nuclear threat and, particularly, the disputes between Japan and China over islands and fishing rights in the South China Sea. The thrust of their questions was whether the world is on the brink of armed conflict in a number of different places and this would destabilize the markets. My views on Russia/Ukraine were described earlier. Regarding Iran, I think the sanctions are working and I probably would have demanded that Iran dismantle its centrifuges before offering any relief, but that may have been diplomatically impossible. Now we have to hope that Iran is serious about reducing its nuclear effort; we should have the answer to that in a few months. Everyone I talk to who is close to the situation is skeptical and reluctant to trust the Iranian government’s commitment, but the people of Iran feel they have been repressed for too long. They want the sanctions lifted so they can participate in the economic opportunity that should emanate from their vast oil resources. The new government in Iran appears ready to respond to the demands of its constituents.

The Israel/Palestine conflict seems unresolvable. Neither a one-state or a two-state solution appears possible. The Arab world refuses to acknowledge Israel’s right to exist and Israel refuses to reduce the settlements in territory it feels is legitimately part of Israel. Even Secretary of State John Kerry is frustrated by his inability to make progress there. As for the South China Sea, which is so important to that region, I am hopeful that a diplomatic solution can be reached. China is very proud of its military progress, but is more concerned with the growth of its economy and not anxious to be distracted by armed conflict with anyone at this time, in my opinion. Perhaps I am naïve in thinking hostilities are not going to take place in any of the major trouble spots in the near term, but over the past decade I think everyone has learned how little has been gained by going to war.

Investors were concerned that the recent sharp decline in the technology, social media and biotechnology stocks signaled the end of the bull market or even the bursting of a bubble in equity prices that began with the market’s rise in 2009. After all, they reasoned, stocks have been rising for most of the past five years and that is the usual duration of a positive cycle. I pointed out that valuations were still reasonable at 16 times forward operating earnings and the U.S. economy was expected to pick up momentum after the brutal weather of the first quarter. The present multiple of the market is about equal to the long-term median. The previous bull market which ended in 2007 reached a multiple in excess of 20 times and the frothy market which ended in 1999 had a peak multiple in excess of 30 times. I still believe the U.S. economy will move toward real growth of 3% and the S&P 500 will turn in a strong performance before year-end. The stocks that have been hit hardest are the big winners of the past year where investors did not want to see their profits melt away. This has been true of the Exchange Traded Funds of the favored sectors where selling has been particularly furious, resulting in sharp liquidations of the underlying stocks.

Asian investors were focused on the tapering by the Federal Reserve which has hurt the emerging markets and many wonder if it will continue. My response was that it will as long as the U.S. economy is growing above 2%, but it might be suspended for a while if the pace falters. As for Europe, there was concern about deflation, but I said that it looked like growth in the Eurozone would be 1% in 2014 and that diminished the deflation threat. The mood in Asia was clearly subdued even though the economies there seem to be doing reasonably well. The International Monetary Fund estimates world growth for 2014 at 3.6%, the U.S. at 2.8%, the Eurozone at 1.2% and emerging markets at 4.8%. With the developing world growing so much faster than its mature brethren, you would think there would be opportunities there. What is needed is renewed confidence on the part of local investors and a willingness to put money into their home market. Right now they are pulling money out. One attitudinal difference between Asian investors I talked with and their American counterparts is their fear that a geopolitical event will send equities tumbling everywhere. American investors are more complacent. I certainly hope the Asians are wrong.


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